financial sector reform: review and prospects*

Financial Sector Reform: Review and Prospects*

I am thankful to Professor Nirvikar Singh for giving me this opportunity to bewith a group of very eminent economists, with deep understanding of various aspects ofIndia’s economy. I have set, for myself, a humble task of presenting before you, aconsolidated account of financial reform measures undertaken so far, and indicate wherewe were before reform and where we are now. Comments and outlook in regard to someof the measures would also be in order, keeping in view internationally acceptablestandards or practices. The main focus would naturally be on the RBI’s role in bankingsector and financial markets. I will conclude by highlighting what emerge as the mostcritical issues that need to be currently addressed.

Main FeaturesThe financial system in India built a vast net work of financial institutions and

markets over time, and the sector is dominated by banking sector which accounts forabout two-thirds of the assets of the organised financial sector. The first phase of currentreform of financial sector was initiated in 1992, based on the recommendations ofCommittee on Financial System (CFS or Narasimham Committee). Briefly stated, themain features of the financial sector reforms undertaken so far are: First, financial sectorreforms (FSR) were undertaken as part of overall economic reform. Second, while thereform process itself commenced in India well after many developing countriesundertook reform, FSR were undertaken early in the reform cycle. Third, these wereorderly as designed by a high-level committee taking into account the prevailingcircumstances. Fourth, while on the regulatory aspects and relevant financial ratios, therewas discernible progress, on structural aspects, especially public ownership and incentivestructures including autonomy of public sector banks, reform process fell short ofexpectations of CFS. Fifth, the reforms have brought about some efficiency, as forexample evidenced by recent reduction in interest spreads or increasing trend inhousehold savings, especially financial savings. Sixth, the financial system and inparticular the banking system displays continued stability relative to other countries.While during the initial stages of the FSR, India was often criticised as being far toogradual, the financial crisis in the past two years which have afflicted a number ofdeveloping countries, not to talk about some developed countries, have shown the meritsof India’s gradual reforms.

Finally, the progress that has been made in a substantial yet non-disruptivemanner, has given confidence to launch what has been described as second generation orsecond phase of reforms - especially in the banking sector.

∗ Keynote address by Dr. Y. V. Reddy, Deputy Governor, Reserve Bank of India, at the Conference on“Growth, Governance and Empowerment: The Future of India’s Economy” at University of California,Santa Cruz on November 20, 1998.I am grateful to Mrs. Shyamala Gopinath and Dr. A.Prasad for their valuable assistance.I am thankful to Mr. Malegam for his kind advice on accounting standards.I am also thankful to Messrs D. Mohanty, M.S. Mohanty, and Dr. D. Ajit for background notes.

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In this background, a second Committee under Mr. Narasimham, who chaired theCFS, was constituted to advice Government on banking sector reforms (CBSR) . TheReport of the Committee (April 1998) provides a framework for the current phase ofreforms. The RBI has already acted on many of the recommendations as perannouncements made in Governor Jalan’s October 1998 Monetary and Credit PolicyReview statement.

RBI’S ApproachRBI’s approach to reform in financial sector has been ably articulated by Dr. C.

Rangarajan in his speeches as Governor, RBI. The approach that governs both the firstand second phase is similar and, could be summarised as pancha-sutra or five principles.

First, cautious and proper sequencing of various measures – giving adequate timeto the various agents to undertake the necessary norms; e.g., the gradual introduction ofprudential norms.

Second, mutually reinforcing measures, that as a package would be enablingreform but non-disruptive of the confidence in the system, e.g., combining reduction inrefinance with reduction in the cash reserve ratio (CRR) which obviously improved bankprofitability.

Third, complementarity between reforms in banking sector and changes in fiscal,external and monetary policies, especially in terms of co-ordination with Government;e.g., recapitalisation of Government owned banks coupled with prudential regulation;abolition of ad hoc treasury bills and its replacement with a system of ways and meansadvances, coupled with reforms in debt markets.

Fourth, developing financial infrastructure in terms of supervisory body, auditstandards, technology and legal framework; e.g., establishment of Board for FinancialSupervision, setting up of the Institute for Development and Research in BankingTechnology, legal amendment to the RBI Act on Non-Banking Financial Companies(NBFCs).

Fifth, taking initiatives to nurture, develop and integrate money, debt and forexmarkets, in a way that all major banks have an opportunity to develop skills, participateand benefit; e.g., gradual reduction in the minimum period for maturity of term depositsand permitting banks to determine the penalty structure in respect of prematurewithdrawal, syndication in respect of loans, flexibility to invest in money and debt marketinstruments, greater freedom to banks to borrow from and invest abroad.Reform Measures and Outlook

Reform measures have been grouped, for convenience, and presented in AnnexureI. The pre-reform position, reform measures undertaken on an year wise basis, currentstatus and comments on outlook are indicated. I will mention here only some significantaspects to link up with critical issues that we intend identifying.Preemptions

Major problem faced by the banking system was on account of constraints,mainly in terms of massive preemption of banks’ resources to finance Government’sbudgetary needs and administered interest rates. Removal of these constraints meant aplanned reduction in statutory preemption and a gradual deregulation of interest rateprescriptions. Since FSR, total effective preemption has been brought down from 54 percent to less than 35 per cent. The effective CRR which was as high as 16.5 per cent has

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been brought down to 9.75 per cent. CRR in excess of 3 per cent is currently remuneratedat 4 per cent per annum. Given that the CRR is a tax on the banking system it is better togradually reduce the CRR rather than maintain a much higher CRR with a relativelyhigher remuneration on these balances. The medium-term objective of reducing CRR hasto take account of money supply considerations and also the objectives of exchange ratestabilisation. Furthermore, reduction of the CRR would depend on manoeuarability onmoney supply impact presently constrained by degree of monetisation of fiscal deficitand uncertainties in forex markets.

Statutory Liquidity Ratio (SLR) has been gradually brought down from anaverage effective rate of 37.4 in 1992 to the statutory minimum of 25 per cent though atpresent, many banks hold SLR well in excess of statutory prescription. Further reductionin SLR, though desirable, would have to await reductions in fiscal deficit apart fromneeded improvements in prudential standards including internal risk managementsystems. Ofcourse, enabling legislative changes would also be needed.

Interest RatesStructure of administered interest rates has been almost totally dismantled.

Prescriptions of rates on all term deposits, including conditions of premature withdrawal,and offering uniform rate irrespective of size of deposits have been dispensed with.Currently, there is a prescribed rate of 4.5 per cent for savings bank accounts which areused by individuals virtually as current accounts and as the cost of servicing theseaccounts is high the remuneration on these accounts has necessarily got to be low. Thereis yet to emerge a consensus on further deregulation of interest rate on savings deposits.There is understandably a differentiated interest rate ceiling prescribed for foreigncurrency denominated deposits from non-resident Indians, and such ceiling will have tocontinue as part of managing external debt flows, especially short-term flows till fullerliberalisation of capital account. Lending rates for different categories, which were earlierprescribed, have been gradually abolished but transparency is insisted upon. Each Bank isrequired to announce Prime Lending Rates (PLR) and the maximum spread that itcharges. However, there are three exceptions. Currently interest rate on smaller advances(i.e., up to Rs.200,000) should not exceed PLR. The element of concessionality of verysmall loans below Rs.200,000 has to be seen in the context of very small loans. As thefigure up to Rs.200,000 has not been adjusted since 1990, the real effective protection forsmall loans has been gradually reduced by the inflation drift. Lending rate for exports arestill prescribed. The prescription of interest rates for exports linked to the period ofavailment is to some extent used as an instrument to influence leads and lags inrepatriation of export proceeds. Finally, ceilings are prescribed in respect of certainadvances in foreign currency, which could be reviewed.

Prudential NormsPrudential norms are being introduced gradually to meet the international

standards. Consequent upon CBSR recommendations, action has already been initiated toincrease the capital adequacy ratio; assign risk weights to Government approvedsecurities, to take care of the market risks; and also assign risk weights to open positionin forex and gold. In most of these, a time table has been indicated for the first phaseonly, so that banks are on notice for the first phase while the RBI has retained the

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freedom to decide on the timing of the second phase. Given the normal growth of 17 to18 per cent in credit, and the required level of capital adequacy after implementing CBSRrecommendations, a substantial infusion of capital into the banking system will bewarranted. This is likely to have significant implications for public sector. Governmenthas to weigh the desirability of further budgetary support vis-à-vis substantial reductionin share of Government ownership of banks. Incidentally, as long as capital markets aresluggish, and their view on banks, bearish, a high proportion of divestment may beneeded to raise the resources needed, since share premia may be low.

Similarly, internationally accepted norms of income recognition have beenintroduced except that income on asset is not recognised if it is not received within twoquarters after it is past due, i.e., due date plus thirty days. The international norm is 90days. Tighter standards, though desirable, have to be introduced gradually so that bothbanks and borrowers have notice to adjust their operations, and there is no seriousdisruption in the normal banking activity or erosion in public confidence in the bankingsystem due to balance sheet impact. Also, a sharp tightening of the norms would pose anunbearable burden on banks and would serve no substantive purpose unlesscorresponding changes are made in credit appraisal systems and debt recoverymechanisms.

Asset classification, which was introduced as per internationally acceptablepractices early in the reform process is sought to be further strengthened gradually, as perCBSR. A significant decision taken relates to treatment of assets guaranteed by the StateGovernment as non-performing under certain circumstances. This is a somewhatexceptional provision to take care of the temporary delays observed in respect of a fewState Governments in honouring their guarantee obligations when invoked.

Competition and TransparencyCompetition is sought to be fostered by permitting new private sector banks, and

more liberal entry of branches of foreign banks. The share of public sector banks in thebanking business is going down, particularly in metropolitan areas. Competition is soughtto be fostered in rural and semi-urban areas also by encouraging Local Area Banks. Somediversification of ownership in select public sector banks has helped the process ofautonomy and thus some response to competitive pressures. The RBI’s efforts to enhancecompetition do, however, take into account the response of public sector banks and theirprincipal, the Government. There are some banking institutions such as cooperatives,regional rural banks and local area banks, which are yet to be brought fully into thediscipline of reform process.

The transparency and disclosure standards have been enhanced to meetinternational standards, though there are a few areas where we are lagging. These relateto maturity pattern of assets and liabilities, movements in provision account and NPAsand progress needs to be made in all these areas. To provide an authentic comparativeinformation on the performance of banks, the RBI’s annual publication `Trend andProgress of Banking in India’ presents, since the last two years, detailed information onindividual banks enabling public assessment of the working of banks.

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SupervisionAn independent Board for Financial Supervision under aegis of the RBI has been

established, and consistent with international practice, focus is also on offsite inspectionsand on control systems internal to the banks. Status of implementation of Core Principlesof Banking Supervision (Annex II) shows that of 46 principles, 33 have beenimplemented, 11 are partially implemented, while only two are yet to be implemented.These two relate to the critical aspect of adequacy of reserves against country risk andtransfer risk; and consolidated reporting. While the former is not a major issue at thisjuncture in view of limited cross border exposure, the latter is of significance warrantingearly action. Even in respect of the Core Principles, which have been implemented, theRBI is making constant efforts to improve the quality of supervision and the skills ofsupervisors.

Credit ControlsSelective credit controls have been dispensed with. Micro-regulation of credit-

delivery has been given up, and there is a greater freedom to both banks and borrowers inmatters relating to credit. However, there are apprehensions on two counts, viz., thediscipline of priority sector lending and flow of credit to the needy and deserving, on atimely basis. The advances eligible for priority sector lending have been enlarged, interestrates deregulated and alternate avenues of investment permitted, thus making the prioritylending far more flexible than before. No doubt, banks are averse to sub-ceilings inpriority sector, and have some problems with procedural requirements. The major area ofserious concern relates to Government sponsored programmes involving subsidies, wherethere are serious problems of both co-ordination and recovery. CBSR has made somerecommendations and these are still under consideration.

There was a general consensus that the real issue in credit-delivery is moreavailability of credit than cost. Consequent upon the deregulation of interest rates, therewas an expectation that credit flow to the needy will be enhanced, but there is somedisappointment about the credit-delivery – especially to small industry. Proceduralsimplifications have been advised by the RBI for rural credit, credit to small industry andmore recently the RBI is working on procedural streamlining for export credit.

Incentives and Legal ReformsThe most critical issue in financial sector reform relates to consequences of the

extent of public ownership and special laws governing publicly owned banks. CBSR hasdevoted a significant part of its report to reform of public sector banks, on whichGovernment, as the principal, needs to act. At present, public ownership has adverseeffects on level playing field among banks, capacity and willingness to compete in themarket place, incentives to perform, and binding work practices/methods that inhibitefficiency. The issue of efficiency in public sector banks has several dimensions, andlegal is one of them. Again, issues of optimal efficiency, autonomy and ownership areintertwined and need to be resolved. Reduction of public ownership below the majoritylevel prescribed would need an amendment to the three different laws that govern publicsector banks. Sale of shares already held by Government also needs amendments to law.

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Debt RecoveryProgress in establishing and operationalising debt-recovery systems has been

painfully slow, partly due to judicial review. CBSR suggested several legislativemeasures that would facilitate debt-recovery, securitisation, electronic systems etc. Aserious consequence of tightening prudential norms and pressurising banks to reduceNPA without strengthening the debt-recovery system is the choking of credit. While largecorporates may be partly spared by recourse to alternate sources such as debentures orcommercial paper, the rest, especially medium and smaller corporates could face creditchoke and hence the pace of introduction of measures needs to be carefully modulated.

Accounting StandardsThere is apprehension in some quarters that the Indian Accounting standards

followed by the Indian banks are not in line with International Accounting Standards.Annexure III gives a comparative position of some of the significant standards relevant tobanking sector and comparative Indian standards/regulations. It will be seen that onaccounting and valuation, Indian standards and defacto practices are comparable withinternational standards. The major area of divergence in accounting is in respect of groupaccounting and consolidation. In India, currently consolidation is not required andinvestments in associated companies are not accounted for under equity method. Inregard to disclosure, Indian banks do not, at present, disclose maturity pattern ofassets/liabilities, concentrations of assets liabilities and off balance sheet items, netforeign currency exposure, movement in provisions account, and gross non-performingassets and related party transactions in the financial statements. However, as regardsdisclosure of related party transactions, banks are prohibited from granting advances tofirms in which a Director is interested. RBI has formally stated that instructions onfurther disclosures will be announced in due course. Meanwhile, many banks are alsotaking steps to build appropriate information systems, which some disclosures entail.

Financial MarketsSince April 1997, the RBI has been taking special efforts to develop the various

segments of the financial markets, in particular, money market, Government securitiesmarket and foreign exchange market (Annexure IV to VI). Significant steps have beentaken to introduce new instruments, strengthen the institutional infrastructure, widen theparticipant base, introduce efficient settlement mechanism, rationalise tax measures, andimprove transparency in operations.

Money MarketIn order to facilitate the conduct of monetary policy, it is essential to improve the

efficiency of transmission mechanism through the money market. Among the measurestaken by the RBI in the recent past are: cautious entry to additional participants in theinter-bank call money market; actions to develop the term money market, the majoramong them being the exemption of inter-bank liabilities from CRR and SLRstipulations; and refinements in instruments such as Commercial Paper, Certificate ofDeposit, inter-bank participation certificate and rediscounting of commercial bills. TheRBI has also been conducting repos of 3/4/14 days both on auction and fixed interest ratebasis, depending on prevailing situation in the market. The medium-term objective is to

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make the call/term money market purely inter-bank market for banks while non-bankparticipants who are not subject to reserve requirements can have free access to othermoney market instruments and operate through repos in a variety of instruments. Thecompletion of documentation and operational details will pave the way for theintroduction of interest rate swaps and other derivative instruments. With proper asset-liability management systems in place, the term money market can also be expected todevelop. An electronic dealing system is envisaged to be operationalised by March 1999.The RBI recognises that a Liquidity Adjustment Facility (LAF) needs to be introduced,but this will depend on the replacement of General Refinance Scheme though notnecessarily on a review of export refinance.

Government Securities MarketWith the switchover to borrowings by Government at market related interest rates,

and more recently, abolition of system of automatic monetisation, it was possible toprogress towards a genuine market for Government securities. Reforms instituted by theRBI in this market include selling of Government securities through auctions;introduction of new instruments such as zero coupon bonds, floating rate bonds andcapital indexed bonds; introduction of Treasury Bills of varying maturities; establishmentof specialised institution, viz., Securities Trading Corporation; institution of system ofPrimary Dealers and Satellite Dealers; institution of the system of Delivery versuspayment; prescription of standard valuation norms; and transparency in operationsthrough market process and dissemination of information.

Future developments in the Government Securities market hinges on three mainissues, viz., legal reforms, technological upgradation and achievement of standardisedpractices. The legislative measures relate to Public Debt Act, to be consistent withmodern technology and market practices; Amendment to Securities Contract RegulationsAct to allow derivatives and give formal jurisdiction to RBI to regulate the Governmentdebt market; and abolition of Stamp duty to avoid transaction costs in debt markets.These are essential for enabling the development of the market. Development oftechnology is an integral part of reforming the debt market and the RBI has embarkedupon the technological upgradation of debt market. Introduction of the Electronic DealingSystem, a Real Time Gross settlement System, integrating the payments and settlementsystems for Government securities are all part of the short-term agenda. Finally,standardisation of practices with regard to manner of quotes, conclusion of deals andcode of best practices are being evolved for repo transactions.

Foreign Exchange MarketMeasures initiated to integrate the Indian forex market with global financial

system include permitting banks to fix their own position limits as per international termsand aggregate Gap Limits; to borrow from and invest abroad up to 15 per cent of theirTier I capital; and to arrange to hedge risks for corporate clients through derivativeinstruments. Other measures such as permitting forward cover for some participants, andthe development of the rupee-forex swap markets also have provided additionalinstruments to hedge risks and help reduce exchange rate volatility. There has been atemporary slow down in further progress due to uncertainties in the market. These

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matters will have to be reviewed from time to time and the process of reform restoredwith appropriate change.

The road map for longer-term developments in the forex markets has been drawnby the Committee on Capital Account Convertibility but a view will have to be taken oneach one of them depending on domestic and international developments, especially thepace of liberalisation of the capital account. In any case, the process of liberalisation ofcapital account itself will, to a large extent depend, inter alia, on progress of financialsector reforms.

Critical IssuesIn identifying critical issues, it is necessary to recognise the strengths of the

Indian banking sector. These include, long history of regulation, early start of financialreforms, stability imparted by reserve requirements, limited exposure to risky assets suchas real estate or stocks or foreign currency, strict control over off-balance sheettransactions, and relatively well diversified credit exposures, rather than undueconcentrations. However, greater efficiency can be brought about, only and only if co-ordinated efforts are made by RBI, Government of India and banks themselves.

Reserve Bank of IndiaFirst, the medium-term objective of reducing preemptions will be pursued, subject

to reduction in fiscal deficit by Government, monetary developments vis-à-vis growth inreal output, and uncertainties in forex markets. Reduction in CRR will help improveprofitability of banks. No doubt, reduction in refinance window will give greaterflexibility in this regard.

Second, on interest rate regime, reform objectives continue to be furtherderegulation and enabling environment for reduction in interest spreads. These wouldagain depend on the progress in reduction of fiscal deficit; reduction in non-performingassets which in turn needs changes in debt recovery system as also improvement in creditappraisal systems by banks themselves; and rationalisation of interest rates in smallsavings, bonds, etc., which are alternatives for savers. Furthermore, inflationaryexpectations do play a critical role in determining interest rates, and these in turn, aredependent on credibility of price stability.

Third, RBI will pursue with implementation of the first phase of reformannounced in October, 1998 and mount the second phase of reform on prudentialrequirements soon. These requirements would, however, warrant significant additions tothe capital of the banking system as a whole. Further progress will depend on resolutionof issues in Government relating to budgetary support, permitting access to capitalmarkets, the strategy for weak banks, mergers, possible changes in the percentage ofpublic ownership, etc.

Fourth, RBI will continue to foster competition between banks and in due coursebetween banks and other financial intermediaries. The issue of competition with otherfinancial intermediaries has to recognise the level playing field argument warrantingspecial treatment to banks as long as they have large preemptions, especially CRR - againlinked to fiscal deficit. As regards competition among banks, the issues relating todiversified ownership, incentive structure and reorganisation of public sector banks haveto be addressed by Government to enable RBI to pursue measures to enhance competition

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without serious systemic implications. RBI will intensify consultations with Centre andStates, on issues relating to co-operatives and Regional Rural Banks.

Fifth, RBI would also pursue vigorously, improvements in transparency,disclosure standards as also accounting standards to attain the best international practices.Similarly, compliance with Core Principles is being expedited. To focus on criticality ofpayment and settlement systems, the October 1998 statement on Monetary Policy has laidout a concrete programme of implementing the banking sector reforms.

Sixth, credit-delivery systems will be improved to ensure smooth credit flow butthis is facilitated only when legal systems and judicial processes are reviewed to replacecumbersome, and time consuming procedures. In addition to laws relating to debtrecovery, changes in bankruptcy law, tenancy laws, urban land ceilings etc. would beneeded to ensure that the collateral offered is in reality a realisable collateral.

Seventh, improvements in financial markets are being so attempted by the RBI asto address both technological and procedural/documentation issues. Development ofmoney and debt markets would also require, among other things, reduction inpreemptions, amendments to Securities Contract Act, replacement of Public Debt Act andresolution of Stamp Duty issue.

Government of IndiaIt is very clear that further progress in financial sector would, to a significant

extent, depend on the resolution of fiscal, legal, and structural issues.First, sustainable level of fiscal deficit is of paramount importance. Furthermore,

cost of raising resources, viz., interest payment for small savings and tax treatment onincome from Government securities need to be reviewed. A view has to be taken onbudgetary support for recapitalisation of banks and contingent liabilities in case AssetReconstruction Company route is favoured. An appropriate approach is also needed onhow the Government sponsored subsidised special programmes of employmentgeneration would operate in the new milieu.

Second, legislative changes that are essential for successful reform are many andCBSR had attempted to address these issues. In particular, legislative changes affectingdebt recovery and growth of financial markets, as already listed, are very critical.Legislative changes may also be needed for greater flexibility in change of publicownership.

Third, structural issues affecting public sector banks have been dwelt at length byCBSR, and suffice to say that the reordering of relationship between Government asprincipal/owner and banks as agents, through legislative changes or otherwise, wouldinfluence the further direction of reform, introduction of competitive pressures andincentive-structures for efficiency-enhancement. Key to financial sector reform isbanking reform; key to banking reform is public sector banking reform; and key to publicsector banking sector reform is Government’s initiative.

BanksIt is clear that actions of RBI and initiatives of Government provide enabling

environment, incentive framework and to some extent punitive measures. The outcomewill depend on the response of banks, i.e., boards of banks, management, officers and

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staff. There are, in particular, four broad areas of internal systems which may needthorough overhauling and which need to be facilitated by Government and the RBI.

First, the internal control systems in the banks, especially Public Sector Banks.Second, the placement, work practices etc., which inhibit incentives for efficiency

and improved customer service.Third, flexibility in obtaining and enhancing highly skilled or talented people.Fourth, introduction and effective use of technology in banks, especially public

sector banks.

ConclusionI trust I have brought to your notice the efforts made by the RBI, the challenges

before us, and the need for co-ordinated actions between the RBI, Government of Indiaand banks themselves. You would appreciate that, by and large, we try to be aware ofwhat is desirable and we are implementing whatever is feasible.

Thank you.

Annexure IBanking Sector Reform

Elements ofReforms

Pre-reform status Reform measures Current status Comments/Outlook

1. Removal ofexternalconstraints(a) Reduction ofpre-emptions

(i) Cash ReserveRatio (CRR)

• CRR 15 percent onNet Demand and TimeLiabilities (NDTL)

• Incremental CRR of10 percent on NDTLover the level ofNDTL as on May 3,1991

• 1992-93 – Incremental CRR of10 percent on NDTL withdrawn.

• 1993-November 1997 – AverageCRR reduced in phases from 15per cent to 9.5 per cent.However, CRR was increasedtemporarily in 1994 formonetary policy reasons. Inter-bank liabilities exempted fromCRR in 1997. During the periodaverage CRR of 15 per cent wasimposed gradually on non-resident deposits andsubsequently removed. In April1997 10 per cent incrementalCRR was imposed on increase inForeign Currency Non Residents(Banks) Liabilities.

• December 1997- January 1998 –CRR increased in phases by 1per cent temporarily forstabilising forex markets andthen reduced to 10 per cent.

• 1998 – CRR hiked to 11 per centfor stabilising forex markets.

• CRR at 11 per cent onNDTL (excluding zero CRRliabilities).

• 10 per cent incremental CRRon FCNR(B) deposits overthe level as on April 11,1997.

• Remaining balances under 10per cent incremental CRRbetween May 3, 1991 andApril 17, 1992.

• In view of exemption of CRRfor certain categories offoreign currency liabilitiesand net inter bank liabilities,effective CRR is 9.75 percent

• Interest on cash balancesmaintained with RBI is paidto SCBs at 4 per cent perannum on eligible cashbalances over the minimum 3per cent of CRR.

• Minimum CRR as per law is 3 percent.

• The reduction in CRR has to takeinto account the reduction in fiscaldeficit, reduction in overall liquidityposition and developments infinancial markets in particular thepossible spill over effects on theforeign exchange markets.

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Elements ofReforms


(ii) StatutoryLiquidity Ratio(SLR)

• SLR 38.5 per cent ondomestic liabilities and30 per cent on non-resident liabilities -effective SLR 37.4 percent.

• 1992-94 – SLR reduced inphased manner through a steeperreduction on SLR onincremental deposits and bybringing forward the base dateevery time. SLR on increase inNDTL over the level as onSeptember 30, 1994 was reducedto 25 per cent. The base levelSLR was reduced to 33.75percent.

• 1997 – In April 1997 interbankliabilities was exempted fromSLR and in October 1997 SLRreduced to 25 per cent on entireNDTL which is the minimumstipulated under Sec. 24 ofBanking Regulation Act. Banksare maintaining on averageabove 30 per cent.

• SLR is 25 percent on NDTLwhich is the minimumprescribed under the BankingRegulation Act.

• Further reduction can becontemplated with reduction in fiscaldeficit.

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Elements ofReforms


(b) Interest ratederegulation(i) Deposit Rates

• Administered interestrates structure on alldeposits includingterm deposits ofvarious maturities.

• Regulations on pre-mature withdrawal ofdeposits and loansagainst fixed deposits

• Interest rate on termdeposits uniform forterm deposits of samematurity irrespectiveof size.

• Foreign Currency(Non-Resident)Deposits Scheme –Interest ratesprescribed by RBI andexchange risk alsoborne by RBI.

• 1992 – Deposits rates were subject to onlyone ceiling rate as against prescribed ratesearlier.

• 1993 – New Foreign Currency (Non-Resident) Deposits (Banks) Schemeintroduced. Exchange risk has to be borneby the banks. Interest rates prescribed byRBI. The earlier scheme was phased outand closed by August 1994.

• 1995-96 – Banks given freedom to fix theirown interest rates on domestic & NREdeposits with maturity of over two yearswhich was later reduced to one year.

• 1997 – Interest rates on bank deposits ofless than one year linked to Bank Rate.

• 1997 – Banks given full freedom todetermine interest rates on term deposits of30 days and above.

• 1997 – Interest rates on foreign currencydeposits to be determined by banks subjectto ceiling rate prescribed by RBI followedby freedom to offer interest rates linked toLIBOR.

• 1998 – Minimum lock in period of termdeposits reduced from 30 days to 15 days.• Banks advised to determine their own

penal rates of interest on prematurewithdrawal of domestic term depositsand NRE deposits.

• Banks given freedom to offerdifferential rate of interest based onsize of deposits of Rs.1.5 mn and over.

• Banks allowed to charge interest rateon loans against fixed deposits notexceeding its Prime Lending Rate(PLR).

• The only administeredinterest rate on rupee ratedeposits is on savings bankdeposits

• On current account balancesno interest is payable.

• Differentiated ceiling rate ofinterest on foreign currencydeposits continues.

• The deregulation ofinterest rates on savingsdeposits will be examinedat the appropriate time.

• The ceiling rate on foreigncurrency deposits willcontinue for sometime as ameasure of prudent debtmanagement.

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Elements ofReforms


(ii) Lending rates • Lending rates structureconsisted of six categoriesbased on size of advances.Under one category theRBI had prescribed aminimum lending rate.

• 1992-1994 –Rationalisation oflending rate structurefrom the earlier sixcategories to threecategories.

• 1994 – Banks givenfreedom to fix their ownPrime Lending Rate(PLR) for advances overRs.2,00,000/- (about US$ 4500/-)

• 1998 – Ceiling rate onloans below Rs.25,000/-fixed at PLR of banks.Lending categoriesreduced to two.

• Both PLR and LTPLR tobe announced by banks

• Spreads over PLR to beannounced.

• Interest rates on advances aboveRs.2,00,000 to be linked to PLR ofeach bank.

• Advances “upto” Rs.2,00,000 not toexceed PLR.

• Export credit rates regulated by RBI.Currently at concessional rate.

• Certain advances denominated inforeign currrency subject to a ceiling.

• Loan against FD not exceeding PLR.

• Ceilings certain on advances inforeign currency could bereviewed

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2. PrudentialNorms(a) CapitalAdequacy

• No capital adequacyrequirements.

• 1992 – Capital to risk assetratio of 8 per cent prescribedas per Basle Committee normsto be achieved in a phasedmanner as follows :Foreign banks by 31 March1993

Indian banks with international

operations by 31 March 1994

Other banks4% by March 19938% by March 1996

• All banks comply with the capitaladequacy ratio of 8 per cent exceptfor 4 banks in private sector and onebank in public sector.

• Capital adequacy ratio increased to 9percent to be achieved by March2000.

• Capital adequacy on market risk forGovt./approved securities has beenannounced which will beimplemented in two phases. 2.5%risk weight by the year ending March31, 2000. Balance of 2.5% will beannounced later.

• Capital adequacy on forex and goldpositions introduced

• Investments in Governmentguaranteed securities of Governmentundertakings which do not form partof market borrowing will be subjectto additional risk weight of 20% from2000-2001.

• Risk weight on outstanding stock ofthe above securities as on 31 March2000 will be implemented in twophases at the rate of 10 per cent eachin 2001-2002 and 2002-2003.

• Risk weights of 20 percent will beassigned for advances guaranteed byState Government where the StateGovernments have remained indefault as on March 31 2000 in caseswhere the guarantee has beeninvoked. The risk weight will beincreased to 100 per cent if theycontinue to be in default after March31, 2001 in respect of such invokedguarantees.

• The Narasimham Committee hassuggested increase in capitaladequacy ratio to 10 per cent. 9per cent to be achieved byMarch 2000 and 10 per cent by2002.

• Decision about furtherenhancement will be announcedlater.

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Elements ofReforms


(b) Incomerecognition

• Income recognition basedon health code systemunder which advanceswere categorised into eightcategories. Of which fourcategories were deemed asnon-performing assets viz.

• (i) debts recalled• (ii) suit filed accounts• (iii) decreed debts• (iv) debts classified as bad

and doubtful. Banks could not recognise

income on these categories.

• No clear definition ofproblem credits

• Subjectivity inclassification of problemcredits.

• Banks cannot recogniseinterest income on all non-performing assets.

• Non performing assetsdefined as on asset on whichinterest is past due for aperiod of four quartersending March 1993, threequarters ending March 31,1994 and two quartersending March 31, 1995 andonwards. Past due is definedas 30 days beyond due date.

• Interest on advancesguaranteed by Governmentwhich is past due for twoquarters should not berecognised as income.However the advances willbe treated as standard assets.

• Banks cannot recogniseincome on assets whereincome is not received withintwo quarters after it is pastdue.

• Banks not allowed torecognise collateral orgovernment guarantees forrecognising interest income.

• The Narasimham Committee II hasrecommended that RBI shouldimplement the international norm of90 days in a phased manner by 2002.

17

Elements ofReforms


(c) AssetClassification

Assets were classified intoeight health codecategories as under :1. Satisfactory2. Irregular3. Sick – viable undernursing4. Sick – Non-viable/sticky5. Advances recalled6. Suit filed accounts7.Decreed debts8. Debts classified by thebanks as bad/doubtfulThe classification was leftto the discretion of eachbank and was notobjective.

• 1992 – All advances have to beclassified by banks into four broadgroups

a) Standardb) Sub-standardc) Doubtfuld) Loss

• As asset is classified as sub-standardwhen the bank stops recognisingincome on accrual basis i.e. when itgets classified as non-performingasset (NPA).

• An asset is classified as doubtfulwhen it remains in substandardcategory for 24 months.

• A loss asset is an asset which isconsidered as irrecoverable and notwritten off..

• In view of the large number ofborrowal accounts classification ofadvances below Rs.25,000/- wasallowed to be done in a phasedmanner but income recognitionnorms were applicable. Thisrelaxation was allowed upto March31, 1998.

• Advances guaranteed by Governmentare not classified as non-performingasset even if income is not beingrecognised on accrual basis.

• The classificationstandards as defined incolumn 3 continue. RBIhas announced in October1998 that an asset will betreated as doubtful if ithas remained in sub-standard category for 18months instead of 24months by March 31,2001.

• Advances guaranteed byState Government will beclassified as NPA ifguarantee is invoked andthe concernedGovernment remains indefault for more than twoquarters with effect fromApril 1, 2000.

• The Narasimham Committee II hasrecommended that an asset beclassified as doubtful if it is in thesub-standard category for 18 monthsin the first instance and eventuallyfor 12 months

• The Narasimham Committee II hasrecommended that for the purpose ofevaluating the quality of assetportfolio Government guaranteedadvances which have turned stickyshould be treated as NPAs. Ifhowever for reason of the sovereignguarantee argument such advancesare excluded from computation, suchNPAs should be separately shown asan aspect of fuller disclosure andgreater transparency of operations.

• Further tightening of norms has notbeen announced.

18

Elements ofReforms


(d) Provisioningstandards

• The provisions to bemade by banks wasleft to the discretionof the bank. RBIInspecting officerswould howeverdetermine whetherprovisions wereadequate to assess thereal value of capitaland reserves.

• 1992 - 10 per cent generalprovision on outstanding sub-standard advances• 100 per cent provision on

unsecured portion ofdoubtful debts.

• 20 per cent to 50 per centprovision on securedportion of doubtful assetsover a three year period.

• 100 per cent on loss assets• On non-performing advances

below Rs.25,000/- banks had tomake a provision on aggregateoutstanding advances withoutnetting for collateral @ 2.5 percent in 1992-93 which wasincreased to 15% in 1997-98.This applied only to banks whichhad not classified the accounts.Banks had to completeclassification of all suchadvances by 1997-98 after whichthe normal provisioning normscame into force.

• 1993 - Banks were allowed tomake provisions on substandardand doubtful assets in March1993 spread over two years. Insubsequent years no suchrelaxation has been given.

• The provisioning norms asindicated in column 3continue.

• RBI has announced thatbanks shall make a generalprovision of a minimum of0.25 per cent for the yearending March 31, 2000.

• Additional provisions arisingfrom the revised definition ofdoubtful asset being phasedin as on March 31, 2001 to bemade over two years as on 31March 2001 and 31 March2002.

• Provisions on advancesguaranteed by StateGovernment which have beeninvoked and remain indefault for more than twoquarters will be made over aperiod of four years from theyear ending 31 March 2000to 31 March 2003 withminimum of 25 per cent eachyear.

• Narasimham Committee II hasrecommended that in case of allfuture loans, asset classification andprovisioning norms should applyeven to Government guaranteedadvances in the same manner as forany other advance. For existingGovernment advances, RBI,Government and banks may work outa mechanism for a phasedrectification of the irregularities inthese accounts.

• The Narasimham Committee II hasrecommended that a generalprovision on standard assets of say 1percent may be introduced in aphased manner.

19

Elements ofReforms


(e) Classificationand Valuation ofInvestmentPortfolio.

• Investments inGovernment and otherapproved securitiescould be carried atbook value withoutrecognising anydiminution in thevalue of the portfolio.

• In the case of otherinvestments banks hadto make adequateprovisions fordiminution in value.

• 1992 - Banks were required to bifurcateinvestments in Government and approvedsecurities into permanent category and currentcategory. Banks had to classify minimum 30 percent of the portfolio as current investments tofacilitate valuing all the investments on fully‘marked to market’ basis.

• 1992 – Guidelines were laid down for transfer ofapproved securities from ‘current’ to‘permanent’ and ‘vice versa’ . These guidelinesensure that latent losses are provided for at thetime of such transfer.

• 1993 - The entire investment portfolio of banksother than investments classified as ‘permanent’has to be classified into six categories for thepurpose of valuation. The valuation will be donefor each category of investments. While netdepreciation has to be provided by debit to theProfit and Loss account, net gains have to beignored. Permanent investments can be carriedat book value. Premium will have to beamortised over the life of the investment butdiscount cannot be recognised as income.

• 1993-1998 The said minimum ratio of 30 percent has been increased in a phased manner to60 per cent as on 31 March 1998. It has furtherbeen decided to increase the ratio to 70 percentfor the year ending March 31, 1999. New privatesector banks are required to mark to market theirentire investments in approved securities from31 March 1997.

• Banks have tomark to market 70per cent of theinvestments inGovernment andapprovedsecurities by 31March 1999.

• RBI hasannounced that inthe next threeyears the entireportfolio will bemarked to market.

• The Indian standards are quitestringent and no further changesare required.

20

Elements ofReforms


3. Competition • Entry of foreignbanks restrictive

• No new privatesector commercialbank licensedsince 1972

• 1991-1998 - A number of foreign banks wereallowed entry into the Indian banking sector.The number of foreign banks operating in Indiaincreased from 21 in 1990 to 43 in 1998.Existing foreign banks were allowed 36additional branches.

• 1993 –In order to introduce greater competitionin the banking sector, the Reserve Bank issuedguidelines in January 1993 for the establishmentof new banks in the private sector. Theminimum paid up capital for these banks is Rs.1000mn The banks will have to be publiclylisted. They are also required to start operationsin a fully computerised environment with stateof the art technology. Foreign banks/foreignfinancial institutions are allowed to have 20 percent stake within the overall non-resident limitof 40 per cent as technical collaborator/partnerin private banks.

• 1994 – 1996 Nine new banks have been set up inthe private sector and one co-operative bank wasallowed to convert to a private commercial bank.

• 1996 – The Union Budget 1996-97 proposedsetting up of new private local area banks withjurisdiction over two or three contiguousdistricts. RBI issued guidelines in 1996 forsetting up of new private local area banks. Theminimum paid up capital for these banks will beRs. 50mn.

• India has madecommitments in theWorld TradeOrganisation (WTO)under the GeneralAgreement on Tradein Services in 1995 togrant eight licencesper year to new andexisting foreign banks.The number wasincreased to 12 in1997. In actualpractice India hasallowed foreign banksto open 15 branches ina year. In addition,off-site ATMs whichrequire a branchlicence are outside thislimit of 12.

• Public sector stilldominates andeffective competitionto them is inmetropolitan areas.

The Narasimham Committee hassuggested that :• Foreign banks may be allowed

to set up subsidiaries/jointventures in India which will besubject to the same regulationson directed credit as Indianbanks.

• The licensing policy for settingup new private banks may bereviewed and no categoryshould be excluded on a priorigrounds. These should be welldefined.

• Revamping of Regional Ruralbanks and establishment ofLocal Area Banks couldfacilitate competition in therural and semi-urban areas also.

• Co-operatives are involved inbanking operations and theseare subject to dual control.

• The licensing policy for newprivate banks is under reviewby a internal Working Group.

21

Elements ofReforms


4. Transparencyand Disclosure

The income in theprofit and lossaccount was shownnet of allprovisions andthereforeprovisions were notdisclosed. Loss onsale or revaluationof investments andother assets couldbe deducted fromincome.Only aggregateamounts under afew categorieswere disclosed inthe Profit and LossAccount. Therewere no schedulesor detailed break-up.The Balance Sheetdisclosure was alsovery limited.Accountingpolicies were notdisclosed.

• The whole format of Profit and Loss Account andBalance Sheet was revised in 1992 with a view toensure greater transparency and disclosure. Therevised format provides for detailed disclosure of allincome items and expenditure items with schedules.The Balance Sheet also is presented in moredetailed format with several schedules. Disclosureof accounting policies has been made mandatory.

• In 1996 banks were advised to include theirassessment of capital adequacy ratio in the balancesheet.

• In 1997 banks were advised to disclose percentageof shareholding of Government, percentage of netNPAs to net advances.

Details of provision made category-wise i.e. towardsNPAs, depreciation etc.Amount of subordinated debt raised as Tier II capital Gross value of investments less cumulativedepreciation.• In January 1998 banks were advised to disclose.Capital adequacy ratio – Tier I capitalCapital adequacy ratio – Tier II capitalInterest income as a percentage of average workingfundsOperating profit as a percentage of average workingfundsReturn on assetsBusiness (deposits and advances) per employeeProfit per employee

• The transparency anddisclosure standardshave been enhancedsubstantially.

• Instructions on furtherdisclosures will beissued in due course.

• The Narasimham Committee IIhas recommended that there isneed for disclosure in a phasedmanner of the maturity patternof assets and liabilities,movement in provisionsaccount and NPAs.

• The annual statutory report onTrend and Progress of Bankingby RBI gives a consolidatedaccount of status of non-performing assets of individualbanks also.

22

5. SupervisorySystem

Dependence on on-site inspection ofbanks.Focus on depositmobilisation prioritysector credit andcredit portfolio.Investment and riskmanagement notgiven muchimportance.Long inspectioncyclesEmphasis was onsolvency and not onother aspects likecapital adequacy,liquiditymanagement etc.

• 1994 – In order to exercise integrated supervisionover credit institutions in the financial system and toensure implementation of regulations in the areas ofcredit management asset classification incomerecognition and treasury operations a Board forFinancial Supervision was set up within the RBI in1994.The supervisory strategy as finalised by BFS in 1994has four components.i) restructuring system of inspectionii) setting up of offsite surveillanceiii) enhancing the role of external auditors andiv) strengthening corporate governance internal

controls and audit functions.• 1995 – An offsite surveillance function has been set

up with the primary objective of monitoring thefinancial condition of banks in between on-siteexaminations identifying banks which showfinancial deterioration and trigger an onsiteexamination.

• The new approach to annual financial inspectionbased on CAMELS (Capital Adequacy AssetQuality, Management Earnings, Liquidity andSystems) framework commenced from July 1997.

• Two supervisory rating models based on CAMELSand CACS (Capital adequacy, Asset Quality,Compliance and Systems) factors for rating ofIndian commercial banks and foreign banksoperating in India respectively have been workedout and would help RBI identify banks wherecondition warrants special supervisory attention.

• The role of the external auditors has been enhancedand enlarged. Besides audit of annual accountsauditors are now required to verify and certify otheraspects as also financial ratios to be disclosed in thebalance sheets.

The system of concurrent audit has been introduced.Each bank has to designate ‘Compliance Officer’ to actas nodal officer.

The RBI supervisorystrategy consists of bothonsite inspections and off-site surveillance. A detailedoff-site surveillance systembased on prudentialsupervisory framework on aquarterly basis covering allimportant areas has beenmade operational. In regardto on-site inspections theprocess is now on theevaluation of the totaloperations and performanceof the bank under theCAMEL system. Apart fromevaluating asset quality andcompliance with prudentialnorms focus is now on theeffective functioning ofBoard management,efficacy of internal auditand control systems and riskmanagement. The entirecycle of inspection andfollow up action is nowcompleted within amaximum period of twelvemonths.

The Narasimham Committee hasrecommended that an integratedsystem of regulation andsupervision be put in place toregulate and supervise theactivities of banks, financialinstitutions and non-bank financecompanies (NBFCs) the agencyto be called Board for FinancialRegulation and Supervision(BFRS). The BFRS should begiven statutory powers and bereconstituted in such a way as tobe composed of professionals. Atpresent, the professional inputsare largely available in anadvisory board which acts as adistinct entity supporting the BFS.The Committee, taking note ofthe formation of BFS hasrecommended that the process ofseparating it from the ReserveBank qua central Bank shouldbegin and the Board should beinvested with requisite autonomyand armed with necessary powersso as to allow it to developexperience and professionalexpertise and to functioneffectively. However, with a viewto retain an organic linkage withRBI, the Governor, RBI should behead of the BFRS.

Supervisory skills of RBI mayneed enhancement, especially tocapture technological changes andnew financial instruments.

23

Elements ofReforms


6. RiskManagement

Focus was entirely on creditrisk and to a large extent onthe management of foreignexchange risk and operatingrisk.a) Credit Risk:Emphasis on toning up ofthe appraisal standard,strengthening post sanctionsupervision and intensivefollow-up of large valueaccounts.Introduction of health codenorms for classification ofadvances, single and groupexposure limits set up byRBI; and banks required toset up industry exposurenorms.b) Foreign Exchange RiskInternal control guidelinesissued in a comprehensivemanner in 1981. Mainemphasis on setting up openposition limits andaggregate gap limits.

c) Operating RiskFocus on fraud reportingand preventive measures;emphasis on house keepingi.e. balancing of books andreconciliation of interbankand inter branch accounts.

a) Credit Risk :Introduction of income recognition and assetclassification norms;Introduction of capital for credit risk as per BasleCommittee’s recommendationDrawing up loan policy and recovery policy bybanksExtending the exposure norms to cover all formsof exposure in addition to credit exposureb) Forex RiskA Committee looked into the entire gamut offoreign exchange markets in IndiaConsequent to the recommendation of thisCommittee, the method of computation of openposition was refined and setting up of openposition limits was made banks specific andliberalisedIntroduction of market risk capital for openposition limits in foreign exchange and gold.More flexible setting up of aggregate gap limits;Introduction of simple value at risk calculation inrespect of forward gapsd) Operating Risk:Intensive monitoring of inter branch, inter bankand nostro accounts, reconciliation by RBIIntroduction of concurrent audit by banksSetting up of Audit Committee of BoardSetting up of compliance officersImplementation of recommendations of JilaniCommittee for strengthening of internal inspectionand audit system in bankse) Treasury OperationsIntroduction of standards for conduct ofinvestment operations including audit andaccounting norms.

Having introduced creditrisk, management attention isnow focussed on market riskmanagement particularly inthe context of deregulationand liberalisation of interestrates. Comprehensive assetliability management systemsare being introduced from1 April 1999 to take care ofinterest rate, liquidity andcurrency risks.

Asset Liability Managementguidelines are to be finalised. Aview has to be taken on theintroduction of capital formarket risk.

24

Elements ofReforms


7. CreditControls/ CreditDelivery System

• Credit delivery mainly inthe form of cash credit forworking capital finance.

• A system of creditauthorisation schemeexisted under which loansavailed by a borrower abovea cut off point had to bereferred to RBI.

• Detailed regulations on howbanks should calculatepermissible bank finance asalso norms for receivablesand inventory holdings ofvarious industries wereprescribed by RBI.

• It was mandatory for banksto form a consortium aboveRs.50 million.

• Regulations on levy ofcommitment charge andlevy of additional interest oncertain portion of book debtfinance.

• Regulations on functioningof consortium arrangement.

• Limits on grant of termloans for projects by banks.

1993 – Banks were given freedom todecide on their own the levels of holdingsof inventory and receivables of variousindustries while assessing creditrequirements of borrowers.1993 – The threshold limit of obligatoryconsortium lending raised from Rs.50million to Rs.500 million.1995-1996 – Loan system for Delivery ofBank Credit for working capital purposewas introduced to bring about greaterdiscipline in credit utilisation and to gainbetter control over borrowers in respect ofborrowers with assessed maximumpermissible bank finance of Rs.200million and above. The cash creditcomponent was initially restricted to 70%and then gradually reduced to 60%, 40per cent and 25 per cent in 1996. Thesystem was also extended to borrowerswith assessed MPBF of Rs.100 million toRs.200 million and cash credit componentfixed at 40 per cent.1996 – The levy of commitment chargewas left to the discretion of banks.Mandatory levy of additional interest oncertain portion of book debt finance wasalso withdrawn.1996 – Participating banks in aconsortium were permitted to frameground rules of the consortiumarrangements.

There is no mandatoryconsortium requirementand borrowers can eitherhave single or multiplebanking arrangements orsyndicate/consortiummethod. The regulations oncredit will form part of theloan policy which has to beformulated by each bankwith Board'’ approval.There is considerableflexibility with regard tocredit delivery systems forborrowers.Procedural simplificationsin regard to agriculture andsmall industry has beenbrought about recently andsuch simplification forexport sector is expectedsoon.

With pressure on banks to reduceNPA’s and in the absence of effectivedebt recovery systems the credit flowespecially to medium and small sectoris reported to be choked.

25

Elements ofReforms


• Selective creditcontrols on sensitivecommodities.

1997 – In order to provide greater freedom in assessing workingcapital requirements all instructions relating to Maximum PermissibleBank Finance (MPBF) were withdrawn and banks were advised toevolve their own methods for assessment. Banks were required to laydown loan policy for each industry for this purpose.

1997 – Mandatory requirement on formation of consortium forborrowal accounts with limit of Rs.500 million and above from morethan one bank withdrawn.

1997 – Limits on grant of term loans for projects by banks waswithdrawn. Banks are free to sanction term loans for projects withinthe ceiling of exposure norms.

1997 – Loan component for all borrowers with credit limit of Rs.100million and above made uniform at 80 per cent.

1997 – Credit Monitoring Arrangement which replaced CreditAuthorisation Scheme was withdrawn.

1996 - Selective credit controls on all sensitive commodities wasabolished except for sugar.

26

Elements ofReforms


8. Priority SectorLending orDirected Credit

• Definition comprisedagriculture, small scaleindustries (includingsetting up of industrialestates), small road andwater transport operators,small business, retailtrade, professional andself-employed persons,State-sponsoredorganisations forSCs/STs, educationalloans granted toindividuals by banksunder their schemes,credit scheme for weakersections and refinance bysponsor banks to RRBs.

• Target for Indian banks:40 per cent of net bankcredit of which directagriculture 18 per cent,advances to weakersections 10 per cent ofbank credit

• Target for foreign banksincludes export sector:

10 per cent by March 198912 per cent by March 199015 per cent by March 1992

1992 – Export credit target of 10per cent introduced.1993 – Foreign banks targetrevised to 32 per cent and whichincludes export credit with subtargets of 10 per cent for exportand 10 per cent for SSI.1993 – Target of 18 per cent foragriculture for Indian banks toinclude indirect advances to theextent of 4.5 per cent of NetBank Credit.1996 – Export sub target raisedfrom 10 to 12 per cent1993 – 1998 – Definition ofpriority sector enlarged toincludei) loans to traditional

plantation crops viz. Tea,Coffee, rubber, cardamom,etc. irrespective of size ofholdings

ii) loans for housing uptoRs.500000.

iii) loans to transport operatorsupto 10 vehicles,

iv) advances to dealers ofdrip/sprinkler irrigationsystem and agriculturalmachinery

v) investments made by banksin special bonds of SIDBI,NABARD, NHB, NSIC,HUDCO, SFCs, SIDCs andREC and contributions toRural InfrastructureDevelopment Fund (RIDF).

vi) banks’ investments in bondsissued by Rural

It is clear from the reformsintroduced in the area that thescope of priority sector credit hasbeen increased and providesopportunities to banks to makeloans on commercially viableterms. There is no element ofinterest subsidy.Further, the markets have anoption to invest short fall inpriority sector lending inNABARD/SIDBI, thus exercisingfreedom not to lend tocommercially unviable activities.Since banks have freedom toinvest in bonds, debentures,shares etc., the resource base forcalculating priority sector lendingis restricted to advances,excluding expanding investments.

• While priority sector lending ascurrently operated is not considered aserious constraint on operations, thereare a variety of government sponsoredprogrammes which are to be fundedby banks. The NarasimhamCommittee has recommended thatgiven the special needs of this sector,the current practice may continue.However, for ensuring greaterinvolvement and accountability andalso appraisal of schemes oncommercial considerations withoutany extraneous influences, the branchmanagers of banks should be fullyresponsible for the identification ofbeneficiaries under the Governmentsponsored credit linked schemes. Thisis yet to be acted upon.

• The Narasimham Committee has alsonoted the changes in the scope ofbeneficiaries under the priority sectorsince the earlier CFS Report wassubmitted and proposes that given theimportance and needs of employmentoriented sectors like food processingand related service activities inagriculture, fisheries, poultry anddairying these sectors should also becovered under the scope of prioritysector lending.

• Banks are also averse to sub ceilingsin priority sector and procedure ofcomputation.

27

Electrification Corporation(REC) for financing itsSystems ImprovementScheme under SpecialProject Agriculture (SI-SPA).

vii) advances to NBFCs foronlending to truck operatorssatisfying priority sectornorms

viii) advances upto Rs.10mn toSoftware Industry .

28

Elements ofReforms


9. Ownership • Nationalised banks arefully owned byGovernment, StateBank of India by RBIand the associates ofSBI by SBI. In thecase of nationalisedbanks there was noprovision for privateparticipation. As therewas no capitaladequacy requirementthere was no need toconsider accessing themarket. In certaincases Governmentprovided the necessarycapital.

• 1993 – SBI Act amended to enhance the scope ofthe provision for private shareholding. RBI sharenot to fall below 55%.

• 1994 – Banking Companies (Acquisition andTransfer of Undertakings) amended effective July15, 1994 permitting nationalised banks to raisecapital upto 49% from the public.

• 1995 – Banking Companies (Acquisition &Transfer of Undertaking Act) amended to enablebanks to reduce the paid-up capital subject to thecondition that the paid up capital cannot bereduced at any time below 25 per cent as on thedate of amendment. This amendment enabledbanks to set off losses against capital.

• 1993 – SBI first public sector bank to raisecapital from the market (Rs.22120 million ascapital). In 1996 SBI raised capital in the form ofGDRs.

• 1994–1998 - Oriental Bank of Commerce, DenaBank, Bank of India, Corporation Bank, Bank ofBaroda, State of Travancore, State Bank ofBikaner & Jaipur accessed capital markets toraise capital. Total capital including premiumraised by all public sector banks amounted toRs.60150 million. (Premium Rs.52540 million).The Government/RBI/SBI shareholding afterpublic issue now ranges from 59.73 to 77% inthese banks.

• Refund of Capital• 1995-1998 - Till date four banks viz. Punjab

National Bank, Bank of India, Bank of Barodaand Corporation Bank have returned toGovernment of India paid up capital aggregatingRs.6421 million. The reduction of capital resultsin an improvement in earnings per share andhelps the banks in better pricing of the share atthe time of public issue.

Currently out of 105commercial banks (excludingRegional Rural banks), 27 arepublicly owned. As perexisting law governing PublicSector Banks, majority ofpublic ownership shouldalways be maintained. In thecase of SBI the RBIshareholding cannot be lessthan 55% and for subsidiariesof SBI, SBI shareholdingcannot go below 55%. Innationalised banks, theminimum Governmentshareholding has to be 51 percent. Eight public sector bankshave so far raised capital fromthe public.

Public sector banks wouldrequire additional capital tomeet their normal assetexpansion as also theenhanced capital requirementsand more stringentprovisioning standards. Theminimum public share of55/51 per cent may become aconstraining factor for somebanks unless the Act isamended.

Related issue is "autonomy"and inhibiting factors such asjurisdiction of vigilance,investigative agencies as longas there is majority of publicownership. Further, the publicsector banks are governed bythree different statues.Narasimham Committeerecommended dilution ofpublic ownership to 33 percent. According to them thereduction of the minimumholding of Government below51 per cent would in itself be amajor and clear signal aboutthe restoration to banks andfinancial institutions ofautonomy in their functioning.

29

Elements ofReforms


10. Legal andInstitutionalReforms:

As per law banks can realise thesecurities pledged to them by filing asuit against the borrower and retainthe pledged goods as collateral till thedebts are satisfied or sell the goods bygiving reasonable notice to theborrower without the intervention ofthe Court. The realisation of debts byfiling a suit takes very long As regardsselling the pledged goods by givingnotice, very often banks do not havethe goods in their possession as theseare mostly inventories and are onlyhypothecated to the bank. In case ofimmovable properties, the law ofmortgage is unsatisfactory as often theright of sale without the interventionof the Court is not available tobanks/financial institutions.• Once a sick industrial company

defined as a company registeredfor not less than five years whosenet worth has been fully erodedstands referred to Board forIndustrial and FinancialReconstruction, no proceedingsfor the winding up of suchcompany or for execution of theproperties of such company or forappointment of a receiver inrespect thereof and no suit filedfor recovery of money or for theenforcement of securities shall lieor be proceeded with further,except with the consent of theBoard.

• Banks and financial institutionstherefore faced considerabledifficulties in recovery of dues

• In order to effect speedyrecovery of loansGovernment passed theRecovery of Debts dueto banks and FinancialInstitutions Act 1993 forthe creation of SpecialTribunals for banks andfinancial institutions.Monetary claims aboveRs. 1 mn and above areadjudicated by the DebtRecovery Tribunals. TheTribunals are expected todispose of such claims ofbanks and financialinstitutions within 6months of suchapplications. Thetribunals follow asummary procedure thatis expected to expeditedisposal of suits filed bybanks.

• Government has set up so far9 Recovery Tribunals covering22 states and 4 UnionTerritories. The constitutionalvalidity of the Act has beenchallenged and is underadjudication of the SupremeCourt. However, the SupremeCourt stayed the operation ofthe Delhi High Court whichquashed the notificationconstituting the Tribunals andallowed the DRTs to function.

• The functioning of the Tribunalshas not been effective as thereare several problems faced bythem. A Working Groupappointed by RBI has madeseveral recommendations toimprove the functioning ofDRTs including amendments tocertain provisions.

• Amendments are beingintroduced to the SICA 1985 inthe Parliament to provide thatthe stay of legalproceedings/suits for recovery ofmoneys or enforcements etcagainst the sick industrialcompanies should operate onlyon the specific orders of theBoard for Industrial andFinancial Reconstruction (BIFR)rather than automatically to limitthe possibilities of misuse of theprovisions of the Act.

• The Narasimham Committee IIhas suggested need for severallegislative amendments toexisting laws which affectoperations of banks includingrecovery through sale withoutjudicial intervention, changes inTransfer of Property Act tofacilitate securitisation,reduction in stamp duties, clarityin law on matters arising fromcomputerisation and electronicfunds transfer, structure of thebanking system etc

• According to the Committee theevolution of legal reforms has

30

from the borrowers andenforcement of security chargedto them due to the delays in thelegal process. A significantportion of the funds is thusblocked in unproductive assets,the values of which keepdeteriorating with the passage oftime.

• The Sick Industrial CompaniesAct further enables borrowers toavoid meeting their obligations asonce the networth is erodedautomatically the Act applies andthey come within the ambit ofBIFR. Thus all proceedingsagainst the company are stayedand banks are unable to effectrecoveries.

not kept pace with the changingcommercial practice and withthe financial sector reforms. As aresult the economy has not beenable to reap the full benefits ofthe reform process.

• In view of the wide-rangingchanges needed in the legalframework, the Committee hasrecommended setting up aExpert Committee to formulatespecific legislative proposals togive effect to the suggestionsmade by them.

• The Finance Minister hasannounced setting up of anExpert Committee.

31

Annexure IISTATUS OF IMPLEMENTATION OF CORE PRINCIPLES OF BANKING SUPERVISION

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 1, Part 1 An effective system of bankingsupervision will have clear cut responsibilities andobjectives for each agency involved in the supervision ofbanks.

ü

Principle 1, Part 2 Each such agency should possessoperational independence and adequate resources.

ü

Principle 1, Part 3 A suitable legal framework for bankingsupervision is also necessary including provisions relatingto authorisation of banking establishments and theirongoing supervision

ü

Principle 1, Part 4. A suitable legal framework forbanking supervision is also necessary including powers toaddress compliance with laws as well as safety andsoundness concerns

ü

Principle 1, Part 5. A suitable legal framework forbanking supervision is also necessary including legalprotection for supervisors.

ü A working group setup by the RBI hasexamined this and concluded that whilestatutory protection is available for acts done ingood faith, the liability of supervisors in case ofnegligence is yet to be tested in law. This willnow be referred to the Expert Group set up byGOI to reexamine Banking related legislation.

Principle 1, Part 6 Arrangements for sharing informationbetween supervisors and protection for confidentiality ofsuch information, should be in place.

ü Interagency cooperation amongst supervisorshas been examined by an inhouse group and theBFS has decided to refer their suggestions toGOI to set up a Technical Group on whichmajor supervisors will be represented.It has also been suggested that a specificprovision be incorporated in the Actauthorising the Bank to share information withother supervisors. This will be looked into bythe Expert Group setup by GOI.

32

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 2, Part 1 The permissible activities ofinstitutions that are Licensed and subject to supervision asbanks must be clearly defined

ü

Principle 2, Part 2 the use of word ‘bank’ in names shouldbe controlled as far as possible.

ü

Principle 3, Part 1 The Licensing authority must have theright to set criteria and reject applications ofestablishments that do not meet the standards set.

ü

Principle 3, Part 2 The Licensing process at minimumshould consist of an assessment of the bank’s ownershipstructure, directors and senior management; its operatingplan and internal controls and its projected financialconditions, including its capital base.

ü A Group was set up earlier this year tocritically evaluate fulfillment of the objectivesenvisaged for the new banks set up in theprivate sector, examine the need for setting upnew banks and suggest criteria for issuingLicenses in future. The issues raised here arealso being looked into by this Group,

Principle 3, Part 3 Where the proposed owner or parentorganisation is a foreign bank, the prior consent of itshome country supervisor should be obtained.

ü

Principle 4 Banking Supervision must have the authorityto review and reject any proposals to transfer significantownership or controlling interests in existing banks toother parties.

üThis matter has been examined and it hasbeen decided to refer this to the Expert Groupwhich will be examining the Banking relatedLegislation.

Principle 5, Part 1 Banking Supervision must have theauthority to establish criteria for reviewing majoracquisitions or investments by a bank

ü

Principle 5, Part 2 Banking Supervision must have theauthority to establish criteria for ensuring that corporateaffiliations or structures do not expose the bank to unduerisks or hinder effective supervision.

ü

33

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 6, Part 1 Banking Supervisors must setminimum capital requirements for banks that reflect therisks that the banks undertake and must define thecomponents of Capital bearing in mind its ability toabsorb losses.

ü

Principle 6, Part 2 For internationally active banks theserequirements should not be less than those established inthe Basle Capital Accord.

ü

Principle 7, Part 1 As essential part of any supervisorysystem is the evaluation of a bank’s policies andprocedures related to the granting of loans and making ofinvestments

ü

Principle 7, Part 2 As essential part of any supervisorysystem is the evaluation of a bank’s policies andprocedures related to ongoing management of the loanand investment portfolios.

ü

Principle 8, Part 1 Banking supervisors must be satisfiedthat banks establish and adhere to adequate policiespractices and procedures for evaluating the quality ofAssets

ü

Principle 8, Part 2 Banking supervisors must be satisfiedthat banks establish and adhere to adequate policiespractices and procedures for evaluating adequacy of LoanLoss Provisions and Loan Loss Reserves .

ü

Principle 9, Part 1 Banking Supervisors must be satisfiedthat banks have Management Information Systems thatenable management to identify concentrations within theportfolio

ü

Principle 9, Part 2 supervisors must set prudential limitsto restrict bank exposures to single borrowers or groupsof related borrowers.

ü

Principle 10, Part 1): In order to prevent abuses arisingfrom connected lending, banking supervisors must havein place requirements that banks lend to relatedcompanies and individuals on arms-length basis,

ü

34

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 10, Part 2): In order to prevent abuses arisingfrom connected lending, banking supervisors must havein place requirements that banks lend to relatedcompanies and individuals on arms-length basis that suchextensions of credit are effectively monitored

ü

Principle 10, Part 3, In order to prevent abuses arisingfrom connected lending, banking supervisors must havein place requirements that other appropriate steps aretaken to control or mitigate the risks.

ü

Principle 11, Part 1 Banking Supervisors must be satisfiedthat banks have adequate policies and procedures foridentifying monitoring and controlling country risk andtransfer risk in their international lending and investmentactivities

üThis issue was examined by the RiskManagement Group which has made severalrecommendations. BFS has desired that thepractice followed by different banks bestudies and the recommendationsresubmitted.

Principle 11, Part 2 Banking Supervisors must be satisfiedthat banks have adequate policies and procedures formaintaining adequate reserves against such risks.

üAlthough the RiskManagement Group has madeseveral recommendationsregarding country risk, thisparticular aspect requires moredetailed study.

Principle 12, Part 1: Banking Supervisors must besatisfied that banks have in place systems that accuratelycontrol market risks;

üBanks will now be required to provideMarket Risk capital based on BIS standardmethodology as a minimum requirement.

Principle 12, Part 2 Supervisors should have powers toimpose specific limits and/or a specific capital charge onmarket risk exposures if warranted.

ü

Principle 13 Banking Supervisors must be satisfied thatbanks have in place a comprehensive risk managementprocess (including appropriate Board and SeniorManagement oversight) to identify measures monitor andcontrol all other material risks and where appropriate tohold capital against these risks.

ü An in-house group has gone into thematter and made several recommendationsregarding Risk Management structures andmeasures to be taken by banks. These will becommunicated to banks for implementation.

35

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 14, Part 1 Banking Supervisors must determinethat banks have in place internal Controls that areadequate for the nature and scale of their business.

ü

Principle 14, Part 2 Banking Supervisors must determinethat banks have in place internal Controls that areadequate for the nature and scale of their business. Theseshould include clear arrangements for delegatingauthority and responsibility, separation of the functionsthat involve committing the bank, paying away its funds,and proper accounts for its assets and liabilitiesreconciliation of these processes; safeguarding its assets;and appropriate independent internal or external audit andcompliance functions to test adherence to these controlsas well as applicable laws and regulations.

ü

Principle 15, Banking Supervisors must determine thatbanks have adequate policies, practices and procedures inplace including strict ‘Know Your Customer’ Rules thatpromote high ethical and professional standards in thefinancial sector and prevent the bank being usedintentionally and unintentionally by criminal elements.

ü

Principle 16 An effective Banking Supervisory Systemshould consist of some form of both on-site and off-sitesupervision.

ü

Principle 17 Banking Supervisors must have regularcontact with bank Management and thoroughunderstanding of the institution’s operations.

ü

Principle 18, Part 1 Banking Supervisors must havemeans of collecting reviewing and analysing PrudentialReports and Statistical Returns from banks on a solobasis.

ü

Principle 18, Part 2 Banking Supervisors must havemeans of collecting reviewing and analysing PrudentialReports and Statistical Returns from banks on aconsolidated basis.

ü Consolidated Reporting bybanks will be implementedafter introduction ofconsolidated accounting whichis being looked into by aninhouse group.

36

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 19 Banking Supervisors must have a means ofindependent validation of supervisory information eitherthrough On-site Examination or use of External Auditors.

ü

Principle 20 An essential element of bank Supervision isthe capability of the supervisors to supervise the bankinggroup on a consolidated basis.

üIntroduction of consolidated supervision ison the agenda of the Bank forimplementation. An inhouse group isexamining related issues.

Principle 21, Part 1 Bank Supervisors must be satisfiedthat each bank maintains adequate records drawn up inaccordance with consistent accounting policies andpractices that enable the Supervisor to obtain a true andfair view of the financial condition of the bank and theprofitability of its business

ü

Principle 21, Part 2 Bank Supervisors must be satisfiedthat the bank publishes on a regular basis FinancialStatements that fairly reflect its condition.

ü

Principle 22 Banking Supervisors must have at theirdisposal adequate Supervisory measures to bring abouttimely corrective action when banks fail to meetprudential requirements such as minimum capitaladequacy ratios when there are regulatory violations orwhere depositors are threatened in any other way. Inextreme circumstances this should include the ability torevoke the banking licence or recommend its revocation

ü

Principle 23 Banking Supervisors must practice globalconsolidated supervision over their internationally activebanks, adequately monitoring and applying appropriateprudential norms to all aspects of the business conductedby these banking organisations worldwide, primarily attheir foreign branches, joint ventures and subsidiaries.

ü The BFS has approved the proposals madeby an inhouse group in this regard and thesewill be now implemented.

37

Core Principle Implemented Partially Implemented Not ImplementedPrinciple 24 A key component of ConsolidatedSupervision is establishing contact and informationexchange with the various other Supervisors involved(primarily host-country Supervisory Authorities).

üThe BFS has approved the proposals madeby an in house group in this regard and thesewill be now implemented.

Principle 25, Part 1 Banking Supervisors must require thelocal operations of foreign banks to be conducted to thesame high standards as are required of domesticinstitutions .

ü

Principle 25, Part 2 Banking Supervisors must havepowers to share information needed by the home countrySupervisors of those banks for the purpose of carrying outconsolidated Supervision.

ü It has been suggested that a specificprovision be incorporated in the Actauthorising the Bank to share informationwith other supervisors. This will be lookedinto by the Expert Group set up by GOI.

46 33 11 2

Annexure III

Accounting Standards as relevant to banksA comparative analysis

Issue International Accounting Standard Indian Standard/Regulation as applicable to banks Comments

1.Asset recognition andmeasurement:I) Investments

a) Definition of currentand permanent

a) A Current investment is an investment that isby its nature readily realisable and is intended tobe held for not more than one year.Ø A long term investment is an investment

other than a current investment.

a) As per international standard. In UK the investments areclassified as current/non-current but in US there arethree categories: (I) held tomaturity for debt securities only(ii) available for sale and (iii)trading.

38

b)Valuation b) Investments classified as current assets shouldbe carried in the balance sheet at market value orthe lower of cost or market value. Thecomparison of cost and market value can beperformed either on an aggregate portfolio basis,in total or by category of investments, or on anindividual investment basis.Ø For current assets held at market value gains

and losses can be included in income or canbe credited to revaluation surplus.

Ø Investments classified as long term assetsshould be carried in the balance sheet ateither:(a) cost(b) revalued amounts(c) in the case of marketable equity

securities the lower of cost and marketvalue determined on portfolio basis.

b) For the purpose of valuation all investments otherthan permanent investments in Government andapproved securities held as permitted by RBI has to betreated as current investments and marked to market.Banks have been advised by RBI to bifurcate allinvestments in approved and Government securitiesinto current and permanent. The minimum ratio ofcurrent investments prescribed by RBI has beenincreased gradually from 30 percent to 70 percent forthe year ending March 31 1999. RBI has alreadyannounced that in the next three years all theinvestments have to be treated as current.The valuation of current investments is done categorywise. Any net gains under each category is ignored butlosses have to be debited to Profit and Loss accountunder Provisions and Contingencies. If on valuation,there is an excess in the provision for depreciationaccount created by earlier debit to profit and lossaccount, it can be written back to profit and loss

Current investments are valuedat the lower of cost and netrealisable value or at currentcost. In US held to maturitysecurities should be held atamortised cost. Trading andavailable for sale securitiesshould be measured at fairvalue.Gains and losses should betaken to income for tradingsecurities but to shareholders’equity for available for salesecurities.The Indian accountingstandards laid down by RBI inconsultation with the Instituteof Chartered Accountants ofIndia is more conservative as

39


If revalued amounts are used, a policy for thefrequency of revaluation should be adopted andinvestments should be valued in entire categories.The resulting changes in carrying value can eitherbe recognised through the income statement oradjusted on owners’ equity as a revaluationsurplus provided that the valuation is above cost.Any revaluation below cost is recognised as anexpense in the income statement. The enterpriseshould recognise any decline in value below costother than on a temporary basis on an item- by-item basis.

account under the head ‘provisions and contingencies’ .However, such excess has to be transferred to CapitalReserve which is allowed to be treated as part of Tier IIcapital and cannot be used for distribution of dividend. In case of unquoted investments the value is to bedetermined on the basis of ‘Yield to Maturity’.However the values have to be further discountedwhere interest or redemption are in arrears.Permanent investments can be held at book value.However, any premium paid has to be amortised overthe life of the investment. Any discount has to beignored. For the purpose of valuation, as stated above,banks are not allowed to treat more than 30 percent oftheir portfolio has permanent investment andprogressively over the next three years the intention isthat the full portfolio should be marked to market.

banks cannot classifyinvestments as permanent oncethe 100 percent mark to marketis achieved. Further bankscannot recognise unrealised netgains as income.

c) Fixed to currenttransfers

c) In cases where current investments are carriedat lower of cost and market, transfer has to bemade at the lower of cost and carrying amount.Any revaluation reserve remaining after thetransfer has to be reversed. Where currentinvestments are carried at market, transfercarrying amount. Transfer any remainingrevaluation reserve to income if the policy oncurrent assets is to take gains and losses toincome.

c) Banks have to recognise the depreciation in thevalue of the investment when it is transferred to currentcategory at the time of such transfer.

d) Current to fixedtransfers

d) Transfer at lower of cost and market or atmarket if that was the basis used.

d) the transfer will be at value net of depreciation.However, with banks moving to 100 percent mark tomarket such transfers will be few.

40


ii) Lease accounting Ø a finance lease is defined as a lease thattransfers substantially all the risks andrewards.UK and US have laid down thepresumptions and conditions in this regard.

Ø The lease depreciation period is usuallyuseful life unless there is no certainty abouteventual purchase when the shorter of usefullife and lease term should be used.

Ø The lessor’s income is allocated on the basisof either net investment or net cashinvestment used consistently according to thecharacter of the lease.

Ø In the case of sale and lease back transactionsof finance leases apparent profit if recognisedshould be taken over the lease term.

Ø finance leases are capitalised anddepreciation provided thereon. The leaseobligation is shown in creditors.

Ø Financial leases like operating leases arecapitalised in the books of the lessor and not in thebooks of the lessee. Indian Accounting Standardon lease accounting ensures that the lease rentalsare allocated between finance charge andrepayment of the lease obligation. A matchingannual charge is made to profit and loss accountrepresenting recovery of the net investment/fairvalue of the leased asset over the primary period ofthe lease.

iii) Impairment of assets Ø There is no specific international accountingstandard on this and each country adopts itsown practice. However an internationalaccounting standard on this issue is expectedshortly.

Ø As far as banks are concerned, each regulatorhas laid down norms for recognition ofincome and for provisions for loan losses orthey rely on the assessment of the externalauditor such as in UK Germany etc.

Ø In India banks follow the detailed norms laid downby RBI for income recognition, asset classificationand provisioning.

41


2. Liability recognitionand measurementi) Contingencies andevents occurring afterthe balance sheet date

Ø The amount of a contingent loss should berecognised as an expense and a liability if (a)it is probable that future events will confirmthat an asset has been impaired or a liabilityincurred at the balance sheet date; (b) areasonable estimate of the amount of theresulting loss can be made. The existence ofa contingent loss should be disclosed in anote to the accounts if it is probable that thegain will be realised

Ø Events which occur after the balance sheetdate but before the date on which financialstatements are authorised for issue mayindicate a need to make adjustments to assetsand liabilities or may require disclosure. Theessential test is whether the event providesadditional evidence about conditions existingat the balance sheet date or provides ifnormatiion relating to the applicability of thegoing concern assumption. For e.g. aborrower becoming bankrupt after thebalance sheet date.

Ø The Indian accounting standards are on par withthe International Accounting Standard In regard tooff balance sheet items the external auditors andRBI inspectors do verify whether contingent losseshave been provided for.

The International Organisationof Securities Companies hascalled for a review of themeasurement requirements ofthis standard as guidance isrequired to define more clearlythe nature of contingencies. Ifthis can be achieved the revisedstandard will provide a basis fordistinguishing on-balancesheet.and off-balance sheetitems. There is also a particularconcern about the use ofprovisions in financialstatements which will also beaddressed when this standardwill be reviewed

ii) Income taxes Ø The international standard requires that adeferred tax liability should be recognisedfor all taxable temporary differences (apartfrom some specific exceptions). A deferredtax asset may be recognised (for the carry-forward of unused tax losses and unused taxcredits) to the extent that it is probable thatfuture taxable profit will be available againstwhich the unused tax losses and unused taxcredits can be utilised. Measurement ofdeferred tax liabilities and assets should be atthe tax rates which are expected to applywhen the liability is settled or the asset isrealised

Ø No provision is made for deferred tax liability ordeferred tax credit. The provision for taxation isbased on the estimated tax liability currentlypayable. This is one area where Indian GAAPdiffers from US/UK GAAP. As far as banks areconcerned they have more of deferred tax credit asprovisions made by them towards non-performingassets are not tax deductible and provisions aremade gross of tax.

42


iii) Employee benefits Ø The contributions are reflected in the profitand loss account

Ø Indian Accounting Standard is in line with theInternational Standard.

(iv) Financialinstruments: Disclosureand Presentation

Ø The standard was made effective fromJanuary 1 1996 in view of the increasing use ofderivatives interest rate swaps etc.Ø In order to provide an understanding of riskfor each class of financial asset, liability andequity instrument disclosure is required of termsconditions and accounting policies, interest raterisk, credit risk fair value and hedges.

Ø In India except for few products allowed formanaging for foreign currency liabilities which aregoverned by conservative limits on positions etcwe are yet to introduce complex derivativesproducts. The standard will be applied when weintroduce these products in the banking sector.

3. Revenue Recognition Ø Revenue is recognised when it is probable thatfuture economic benefits will flow to theenterprise and these benefits can be measuresreliably.

Ø The standard applies this principle to the saleof goods, the rendering of services and the riseby others of enterprise assets yielding interest,royalties and dividends.

Ø Revenue should be recognised on thefollowing basis.

Ø Interest should be recognised on a timeproportion basis that takes into account theeffective yield on the asset

Ø Dividends should be recognised when theshareholder’s right to receive dividend isestablished.

Ø The Indian standards are on par with IAS. Banksare allowed to recognise interest and otherincome on accrual basis. However, if interest ispast due for two quarters, it cannot be recognisedon accrual basis.

4. Effects of changes inforeign exchange rates

Ø The financial statements are affected byforeign exchange rates in two ways. Theenterprise may undertake transactions inforeign currency, alternatively it may operatepart of its business in a foreign country whichhas a different currency.

Ø The recognition of effects of changes in foreignexchange rates in respect of foreign currencytransactions are as per international standard.

Ø In regard to translation of financial statements ofoverseas branches of Indian banks, the RBIinstructions are that any translation gains shouldnot be recognised as income but transferred to aseparate account in the balance sheet.

43


. Ø Foreign currency transactions should berecorded in the reporting currency of theenterprise by applying the exchange raterelevant at the date of the transactionexchange differences arising from settlementor reporting of monetary items should berecognised as income or expenses in theperiod in which they arise.

Ø The method of accounting for transactiondepends on whether the foreign operations areintegral to the operations of the reportingenterprise or whether it is an operation whichenjoys a significant degree of autonomy fromthe reporting enterprise.

5.Group accounting Ø a parent which issues consolidated financialstatements should consolidate all subsidiariesforeign and domestic with few exceptions. Forexample where a subsidiary operates undersevere long term restrictions whichsignificantly impair its ability to transfer fundsto the parent.

Ø The international accounting standards dealwith many of the problem areas of groupaccounting such as foreign exchange rates; thenature of a business combination;consolidated financial statements andinvestments in subsidiaries; investments inassociates and interests in joint ventures.

Ø Investments in associated companies areaccounted under the equity method.

Ø Consolidation is not required.Ø Investments in associated companies are not

accounted for under equity method. Investments arecarried at cost.

Ø In the case of banks as consolidated supervision isone of the core principles for effective bankingsupervision, it is proposed to call for a off-sitereporting on consolidated basis.

44


6. Disclosure andpresentation –International AccountingStandard 30 whichspecifically deals withdisclosure in thefinancial statements ofbanks and other similarfinancial institutionsIncome statement 1. Accounting policies disclosure 1. Accounting policies are disclosed

2. Income statement: A bank should present anincome statement which groups income andexpenses by nature and discloses the amounts ofthe principal types of income and expenses

2. income statement complies with internationalstandard

3. Income and expenses should not be offsetexcept for those relating to hedges and to assetsand liabilities where there is a legal right to set offand the offsetting represents the expectation as tothe realisation or settlement of the asset orliability.

3. IAS compliant

Balance sheet 4. a bank should present a balance sheet thatgroups assets and liabilities by nature and liststhem in an order that reflects their relativeliquidity.

4. Assets listing reflects liquidity but not the liabilities.

Investments 5. a bank should disclose the market value ofdealing securities and marketable investmentsecurities if these values are different from thecarrying amounts in the financial statements

5. Market value of current investments is disclosed.Market value of permanent investments is not disclosed.

6. the amount at which any asset or liability isstated in the balance sheet should not be offset bythe deduction of another liability or asset unless alegal right of set-off exists and the offsettingrepresents expectation as to the realisation orsettlement of the asset or liability.

6. IAS compliant

45


Contingencies andcommitments

7. a bank should disclose specified contingenciesand commitments and events occurring after thebalance sheet date as already stated above.

7. IAS compliant – as per assessment of externalauditors

Maturity pattern ofassets and liabilities

8. a bank should disclose an analysis of assets andliabilities into relevant maturity groupings basedon the remaining period at the balance sheet dateto the contractual maturity

8. Banks are yet to build up information on maturitypattern. RBI has advised banks to put in place suitablesystems to capture this information.

Concentrations of assets,liabilities and off-balance sheet items

9. a bank should disclose any significantconcentrations of its assets liabilities and offbalance sheet items. Such disclosures should bemade in terms of geographical areas, customer orindustry groups or other concentrations of risk. Abank should also disclose the amount of significantnet foreign currency exposures.

9. The banks disclose exposures to public sector prioritysector Government and banks. Secured and unsecuredexposures are also disclosed.

Losses on loans andadvances

10. a bank should disclose the following in regardto losses on loans and advances:• the accounting policy which describes the

basis on which uncollectable loans andadvances are recognised as an expense andwritten off.

• details of the movements in provisions forlosses on loans and advances during theperiod.

• the aggregate amount of the provision forlosses on loans and advances at the balancesheet date and

• the aggregate amount included in the balancesheet for loans and advances on which interestis not being accrued and the basis used todetermine the carrying amount of such loansand advances.

10 The following disclosure is mandatory.

Ø accounting policiesØ provisions made during the yearØ net non-performing assets to net advances

Indian regulations not IAS compliant.

Related partytransactions

11. .related party transactions should be disclosed 11. Not disclosed. However, as per Banking Law, banksare prohibited from giving loans to companies/firms inwhich directors are interested

46

Annexure IVMoney Market

Elements of Reform Pre-Reform Status Reform Status Current Status Comments/outlook

1. Call/Notice/Term MoneyMarket

• Only banks were allowed toparticipate in market asborrowers and lenders.

• Financial institutionsallowed as lenders.

• CRR/SLR required to bemaintained on interbankliabilities.

• Telephone oriented market.

• Primary Dealers allowed aslenders and borrowers.

• Private Mutual Fundsallowed as lenders.

• Routing of transactionsallowed to entities throughDFHI as lenders withminimum size of operationsat Rs.20 crore, which wasreduced gradually to Rs.3crore.

• IDBI/ICICI/IRBI/SIDBI/EXIM Bank and NABARDpermitted to borrow fromterm money market forperiods 3-6 months withinstipulated ceilings.

• Interbank liabilitiesexempted for purpose ofCRR and SLR subject tostatutory ceiling on NDTL.

• Telephone oriented market

• Banks and PDs arepermitted to lend andborrow. FIs/insurancecompanies/mutualfunds/corporate entitiesthrough PDs are permittedto lend. CRR/SLRexempted for interbankliabilities. Reference rateemerging throughReuters/NSE.

• Proposal to make thecall/term money marketpurely an interbank marketwith only banks/PDsoperating as lenders andborrowers.

• Others to operate throughrepo.

• Proposal to operationaliseElectronic Dealing System.

• ALM guidelines to limitexposure of banks in callmoney market.

2. Commercial Paper • Issued by corporates• Discounted instrument• Prior permission of RBI

required.• Issue of CP linked to

Maximum PermissibleBank Borrowing (ceiling onaggregate amount of CPlinked to fund basedworking capital)

• Facility of stand-byavailable

• Requirement of minimum

• PDs are also allowed toissue CP

• Discounted instrument• Prior permission of RBI

dispensed with• Ceiling increased to 100 per

cent of working capital• Facility of stand-by

abolished.• Requirement of minimum

current ratio dispensedwith.

• Minimum size of CP to

• Corporates and PDs arepermitted to issue CP as adiscounted instrument for aminimum maturity of 15days and maximummaturity of 1 year.

• The minimum size of CP isRs.25 lakh.

• The issue requires to berated.

• Banks, FIs, NRIs on a non-repatriable basis andindividuals can invest in

• Rationalisation of stampduty structure

• Electronic Dealing System.• Variation to instrument

such as coupon bearing CPand floating rate CP.

47

current ratio (1.33 :1)• Minimum size of CP issue

at Rs.1 crore indenomination of Rs.25lakh.

• Maturity range of 3-6months.

• Rating required

investor reduced to Rs.25lakh with denomination ofRs.5 lakh.

• Minimum maturitygradually reduced to 15days and maximummaturity elongated to 1year.

• Rating required.

CP.

3. Certificate of Deposits • Issued only by commercialbanks (excluding RRBs) asa discounted instrument.

• Minimum size of CD : Rs.1crore, and issued inmultiples of Rs.25 lakh.

• Minimum maturity of CDshould not be less than 3months and maximummaturity not more than 1year.

• Bankwise limit on issue ofCD at 1 per cent offortnightly averageoutstanding aggregatedeposits in the previousyear.

• Initial lock-in period of 45days.

• Financial institutions canalso issue CD for maturity1-3 years.

• Minimum size of CDgradually reduced to Rs.5lakh.

• Bankwise limits graduallyraised up to 10 per cent andlater withdrawn.

• Initial lock-in periodreduced gradually to 15days.

• Banks and FIs can issueCDs for maturity of 3months to 1 year and 1 to 3years, respectively.

• CD is issued as adiscounted instrument.

• The minimum size of CD isRs.5 lakh and the minimumlock-in period is 15 days.

Rationalise the maturitystructure of CDs.Rationalise stamp dutystructure.Variation to instrument such asinterest bearing CD and floatingrate CD.

4. Money Market Mutual Funds • Did not exist. • Can be set up by ScheduledCommercial Banks/PFIsdirectly or through theexisting mutual funds asMMDA or MMMF

• NRIs can invest on non-repatriation basis.

• Initial Minimum lock-in-period – 46 days.Subsequently reduced to 15days

• Units could be issued to

• In principle approval hasbeen given for 10 banksand institutions to set upMMMFs/ MMDAs.

• IDBI, UTI and KothariPioneer Mutual Fundshave floated MMMFschemes.

• MMMFs permitted toinvest in corporatedebentures/bonds with

• Consider reduction inminimum holding period of15 days.

• Consider cheque issuancefacilities.

48

Corporates and others onpar with other mutual funds(April 1996)

• Investment in moneymarket instruments such asCP/T-Bills/CD/DatedSecurities with maturityless than one year.

• Launched 100 per cent Giltfund with liquidity supportfrom RBI.

maturities less than oneyear, within limits.

5. Commercial BillsRediscounting

• Maturity of commercialbills not to exceed 30 days.

• All participants in the callmoney market areparticipants in this market.

• No ceiling on interest rates.• No minimum period of

rediscounting.

• Minimum period of 15 daysprescribed for rediscounting(April 1995).

• All participants in the callmoney market canrediscount commercial billsfor a minimum period of 15days.

49

Annexure VGovernment Securities Market

Elements of Reform Pre-Reform Measures Reform Measures Current Status Comments/Outlook

1. Policy • Absence of internal debtmanagement policy

• Automatic monetisation ofbudget deficit through asystem of ad-hoc T-Bills atinterest rate of 4.6 per cent.

• System of Tap T-Bills at4.6 per cent.

• Active debt managementpolicy .

• Abolition of system of Ad-hoc T-Bills (since April 1,1997) and introduction ofsystem of ways and meansadvances (WMA) withinagreed limits at Bank rate.Maximum period ofoverdraft at Bank rate plus2 percentage points.

• Tap T-Bills replaced by 14-Day Intermediate T-Bills(since April 1, 1997).

• Limit of WMA for the firsthalf of 1998-99 fixed atRs.11,000 crore and for thesecond half at Rs.7,000crore.

• Monitoring Group of Cashand Debt Marketconstituted with RBI anddebt officials.

• Limits of WMA to bereviewed further.

• No overdraft will bepermitted beyond 10 daysafter March 31, 1999.

2. Dated GovernmentSecurities

• Dated Securities sold at lowpreannounced coupon rate.

• Long-Dated Securities of20-30 years were beingissued.

• Instrument used was plainvanilla fixed couponsecurity

• Securities sold throughauction process (June1992).

• Discriminatory type ofauction (June 1992).

• Maturity of security usuallynot more than 10 years.

• Variety of instruments usedsuch as zero-coupon bonds,floating rate bonds, partlypaid stock, capital indexedbonds, etc.

• Notified amountpreannounced in respect ofeach auction (Oct 1998).

• A portion of the notifiedamount underwritten byPrimary Dealers (PDs)(since June 1997). Thisreplaced the system ofcommission introduced in

• Securities generally soldthrough discriminatoryauction process.

• Securities also sold atmarket relatedpreannounced coupon rateand also on tap, dependingon prevailing conditions.

• Can consider newinstruments.

• Aim to move to totallymarket clearing yields atauctions.

50

July 1996.3. Treasury Bills • 14-day Tap T-Bills at a

coupon of 4.6 per cent• 182-Day T-Bills

• Tap T-Bills replaced by 14-Day Intermediate T-Bills(April 1, 1997).

• A variety of T-Bills exist –14-Day, 91-Day and 364-Day. 182-day T-billswithdrawn.

• T-Bills sold throughauction basis (since April1992).

• Notified amounts pre-announced

• Non-competitive bids(allowed in respect of 14-Day and 91-Day T-Bills)kept outside notifiedamounts.

• T-Bills auctionunderwritten by PDs.

• T-Bills sold throughauctions.

• 14-Day and 91-Day T-Billsauctions held every Fridayand 364-Day auctions everyalternate Wednesdays.

• Discriminatory auctionsused in respect of 14-dayand 364-day T-Bills anduniform type auction inrespect of 91-Day T-Bills.

• Notified amount varieddepending on prevailingmarket conditions.

• Announced intention tointroduce 28-day T-Billsand reintroduce 182-day T-Bills.

• Could sell through uniformor discriminatory auctionsdepending on experiencegained.

4. Institutional Development • No specialised institution • Securities TradingCorporation of India Ltd.Promoted by RBI (July1994) to develop trading inGovernment Securities.

• A system of PrimaryDealers (March 1995) andSatellite Dealers (December1996) have beenestablished to activateprimary and secondarymarkets and retailGovernment Securities.

• RBI has diluted most of itsholdings in STCI and is aminority shareholder.

• STCI has acquired PDstatus.

5. Primary Dealers • Did not exist. • Initially six PDs licensed(March 1996).

• PDs given biddingcommitments.

• PDs have access to callmoney market both asborrowers and lenders(March 1996) and can raise

• Recently, seven new PDshave been given in-principle approval (October1998).

• Individual PDs cannotunderwrite more than 30 %of the notified amount.

• PDs have formed an SRO

• Consider increasing thenumber of PDs.

• Increase the proportion ofunderwriting to 100 % ofnotified amount.

• Consider introducing when-issued market.

51

funds through issue of CP,by way of loans from banksand from the intercorporatemarket (September 1996) .

• PDs underwrite 50 % ofnotified amounts in auction(August 1998).

called Primary DealersAssociation.

6. Satellite Dealers • Did not exist. • Nine SDs registeredinitially (Nov 1997).

• Two in-principle approvalgiven to banks (Nov 1997).

• SDs do not have access tocall/notice money market.

• Four out of nine SDs havegraduated as PDs.

• SDs permitted to issue CP(June 1998).

• Consider increasing thenumber of SDs.

7. Settlement System • Through SubsidisedGeneral Ledger Accountsmaintained in the PublicDebt Office of RBI.

• Banks, FIs, PFs holdingSGL accounts.

• Manual Accounting and noDelivery Versus Payment.

• Through SGL accountsmaintained in PDO of RBI

• Computerised environmentwith DVP system forsettlement.

• Participants given twoSGL accounts, one for owntransactions and the otherfor constituents.

• PFs asked to close SGLaccounts with RBI andencouraged to openconstituent accounts withbanks, etc.

• DVP system in operation.• Banks/FIs/PDs/NSE/NSDL

/SHCIL have SGL andcurrent account with RBI.

• To move to real time grosssettlement system.

• To integrate SGL andcurrent account.

8. Secondary Market Trading • Transactions conductedover telephone.

• Transactions routed throughbrokers.

• Tax deducted at source(TDS) in respect of incomefrom secondary markettransactions.

• Transactions continue to beconducted over telephone.

• Transactions are usuallydirectly betweencounterparties.

• If routed through brokersthey must be through arecognised stock exchange.

• Individual broker limitsfixed for banks. Anyincrease in broker limitsneeds ratification by bankBoards.

• TDS abolished.

• PDs, foreign banks and newprivate sector banks areusually active in thesecondary markets.

• PDs are expected to giveactive two way quotes.

• Electronic Dealing Systembeing put in place.

• Ease in individual brokerlimits may be considered.

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9. Inter-Bank Repos • Freely done • Heavily restricted• Banks and PDs can borrow

and lend through repos(June 1994).

• Mutual funds/other selectholders can lend throughrepos (April 1997).

• Minimum period of reporeduced to 1 day (October1998).

• Banks and PDs can lendand borrow through repos.

• Non-bank participants whoare lenders in call moneymarket can lend throughrepos.

• Minimum period of repos isone day

• It is proposed to make theinterbank call moneymarket purely interbank.The sequencing will requireall non-bank participants toallow access to the repomarket in Government andNon-Government debt indematerialised form

• Encouragedematerialisation of non-Government debt.

• Introduce different form ofrepos.

• Introduce code of conductfor market practices andstandardised contracts forrepos.

10. RBI Repos • RBI conducts 3 /4/14 dayrepos.

• Repos conducted both onauction basis and fixed ratevolume tender (Nov 1997).

• Currently RBI conducts3 /4 day repos on fixed ratevolume tender basis.

• 1 day repo beingcontemplated and will beconducted as and whennecessary.

11. Foreign Investment • NRI/ Overseas CorporateBodies/ ForeignInstitutional Investors canoperate Dated Securities inprimary and secondarymarkets.

• Since May 1998, FIIspermitted investment in T-Bills also in both primaryand secondary markets.

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Non-Government Debt Market

Elements ofReform

Pre-Reform Status Reform Measures Current Status Comments/ Outlook

1. PSU Bonds • Tax-free and taxablebonds permitted to beissued.

• Maximum interestrate on taxable bondsat 14%.

• Maximum interestrate on tax-free bondsfixed at 10%

• Ceiling of banksinvestments in PSUbonds and corporatedebentures at 1.5 percent of incrementaldeposits.

• Tax-free and taxable bondscontinue to be permitted.

• Interest rate on taxable bondsfreed

• Ceiling on tax-free bonds raisedto 10.5 per cent.

• Repos permitted in PSU bonds indemat form and throughrecognised stock exchanges

• Ceiling of banks investments inPSU bonds removed.

• PFs initially allowed to invest15% of their incremental depositsin bonds of PSUs and publicfinancial institutions

• Taxable and tax-free bonds can beissued. There is ceiling of 10.5%on tax-free bonds and no ceiling ontaxable bonds. Banks can investfreely in PSU bonds. There are avariety of bonds in the market.

• Repos are permitted if PSU bondsare in demat form and donethrough NSE. But, yet to take offas Stamp Duty clearances awaited.

• Limit of PFs investment in PSUbonds increased to 30 per cent.

• Proposal to rationalisestamp duty structure topromote secondarymarket trading.

2. Corporate Debt • Interest rate ceiling of14% on taxabledebentures

• Conversion in respectof convertibledebenturescompulsory

• Ceiling of banksinvestments in PSUbonds and corporatedebentures at 1.5 percent of incrementaldeposits.

• Traditional debtinstruments

• Interest rate ceiling removed.• Conversion made optional at the

choice of investor.• Ceiling on banks investments in

PSU bonds removed.• Innovative instruments such as

deferred interest secured paymentnotes, Non-convertible debentureswith detachable equity warrants,Zero interest fully andconvertible instruments,optionally fully convertibledebentures, debentures with calland put options, step-up interestrates, deep discount bonds, etc.

• A variety of corporate debtinstruments are available. Bankscan invest freely in suchinstruments.

• Announced the intention tointroduce interest rate swaps

• Innovation will continue.• Derivatives will be

introduced.

InstitutionalDevelopment

• Securities andExchange Board ofIndia set up as aregulatory body

• SEBI accorded statutory status.Office of Controller of CapitalIssues abolished.

• National Stock Exchange set up(screen-based dealing).

• SEBI is the regulator. There aredepositories like NSDL andcustodians like SHCIL.There is anelectronic stock exchange in theform of NSE and a stock exchangefor small value instruments like

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• OTCEI set up (for small valuesecurities).

• Stock Holding Corporation ofIndia set up (custodial services).

• National securities DepositoryLtd. (Depository).

• Credit Rating Agencies set up.

OTCEI.

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Annexure VIForeign Exchange Market

Elements ofReforms


1. ExchangeRate Regime

• Exchange rate officiallydetermined by RBI in terms of aweighted basket of currencies ofIndia's major trading partners. Theregime was characterised by dailyprice setting by RBI.

• Given the RBI's obligation to buyand sell unlimited amounts of theintervention currency i.e., poundsterling, arising from the banks'merchant purchases, its quotes forbuying/selling effectively becamethe fulcrum around which themarket moved.

• Debt Service Payments were routedthrough foreign exchange reserves.

• A significant two stage downward adjustmentin the exchange rate of the rupee took place onJuly 1 and 3, 1991.

• Simultaneously EXIM Scrip scheme wasintroduced. LERMS was in place during1992-93, under which 40 per cent of theproceeds of the exchange earners had to besurrendered at the official rate and 60 per centat the market rate. With effect from March 1,1993, the exchange rate of the rupee wasunified and the era of fully floating market-determined exchange rate began.

• RBI discontinued quoting of buying andselling rate from October 4, 1995. The RBInow quotes its buying rate to any authoriseddealer on receiving a specific request.

• With effect from July 3, 1995 Debt ServicePayments routed through the market.

• Exchange rate of the rupeeis market determined, basedon the demand and supplyof foreign exchange.

-

2. OvernightPositions/Aggregate GapLimits (AGL) ofAuthorisedDealers (ADs).

Uniform limit of Rs 15 crore on theovernight positions of ADs. AGL not to exceed US $ 100 million orsix times the net owned funds of a bank.

• Consequent upon the recommendations of theExpert Group on Foreign Exchange Market(Chairman: Shri O.P. Sodhani), the uniformlimit of Rs 15 crore on the overnight positionsof the ADs was removed with effect fromJanuary 4 1996. Banks allowed to operate onthe limits fixed by their management’s andvetted by RBI.

• Aggregate Gap Limit (AGL) was left to befixed by the individual banks since April 1996depending upon their foreign exchangeoperations, risk taking capacity, balance sheetsize and other relevant parameters subject tothe approval from the Reserve Bank.

• Since August 20, 1998, ADsadvised to report (at closeof business everyday) theiropen position as at 10.a.m.as also their peak intra-dayposition

-

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Elements ofReforms


3. CrossCurrencyOptions andderivativeProducts

• No cross currencyoptions/derivative products wereavailable.

• Banks not permitted free tradingopportunities in the overseasmarkets.

• Since April 1996, ADs were allowed toinitiate cross currency position overseas, tocancel and rebook cross currency options andoffer derivative products to enable theircustomers to hedge their external liabilities.

• Since August 1996, ADs allowed to offer (a)Interest rate swaps (b) Currency swaps,(c)Coupon swaps, (d) Purchase of interestrate caps/collars and (e) Forward rateagreements to their corporate clients for theirasset-liability management either by bookingthe transactions overseas or on a back-to-back basis, without prior approval of thegovernment or the Reserve Bank. Payment ofupfront premia as well as other chargesincidental to the hedge transactions couldalso be effected by ADs without priorapproval of the Reserve bank.

• Since September 1996, ADs accordedfreedom to offer to their customers costreduction strategies and risk-reduction optionstrategies like Range Forwards, Ratio RangeForwards etc. subject to the condition thatthere is no net inflow of premium to thecustomers by shorting volatilities. Corporateswere allowed to freely book and canceloptions.

- -

4. ForeignCurrencyLoans.

• Banks not allowed to offer foreigncurrency loans from the pool of non-resident deposits.

Banks permitted in October 1996 to provideforeign currency denominated loans to theircustomers out of the pool of FCNR(B) deposits.

- -

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Elements ofReforms


5. Overseasborrowings/investments bybanks.

Banks not permitted • ADs were permitted in April 1997 to borrowfrom their overseas offices/ correspondents aswell as to invest funds in overseas moneymarket instruments up to US $ 10 million. InOctober 1997, this limit was raised to 15 percent of the Tier I capital of the banks.

• Limit modified to include overnightinvestments out of nostro account balances ofthe banks.

• ADs advised informally notto arbitrage between themoney and foreignexchange markets whichcould bring in additionalvolatility in the market.

• As the forex marketdeepens further and themarkets becomeintegrated, this limitwould be raised.

• The Report on CapitalAccount Convertibiltyrecommends that theonly restriction shouldbe Section 25 of BR Act,1949 and openposition/gap limits.

6. ForwardMarket

• To access the forward marketcorporates were required toproduced ocuments evidencingexposure.

• Unlimited cancellation andrebooking of forward contracts notallowed.

• The participants in the forwardmarket were limited.

• ADs permitted to book forward cover forexporters and importers on the basis of adeclaration of exposures supported by pastperformance and business projection providedthe total forward contracts outstanding at anypoint of time did not exceed the averageexport/import turnover of the last two years.

• Corporates were given complete freedom in1992 to actively hedge their exposures byfreely booking and cancelling forwardcontracts.

• Since December 1, 1997 rebooking of forwardcontracts on non-trade transactions for thesame underlying exposure was banned andonly rollover was allowed.

• Since August 20, 1998, it was decided towithdraw the facility of rebooking cancelledcontracts for trade related transactionscovering imports. However, contracts can berolled over before maturity.

• Participants in the forward market have beenincreased considerably. In August 1997, FIIswere allowed to cover their debt exposures inthe forward market.

• In October 1997, the facility of forward coverwas extended to NRI depositors in respect of

• Booking of forward contractbased on presumptiveexposure temporarilywithdrawn since December2, 1997 in view of thevolatility in the forex marketand presently forward coveris allowed based only ondocuments evidencingexposures.

• Facility for rebooking ofcancelled contracts ispresently available only forexports. Rebooking ofcancelled contracts is notallowed in case of non-tradetransactions and imports.

• The need for documentsto enter into a forwardcontract would bewithdrawn.

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deposits held in Non Resident (External)Rupee accounts [NRE(R)A] and ForeignCurrency Non-Resident (Banks) [FCNR(B)]schemes

• With effect from June 12, 1998, forward coverfacility for equity investment by FIIs wasmade available for "incremental investments"(over and above the level of investment inequity prevailing at the end of business onJune 11, 1998).

• Since August 20, 1998, ADs were allowed tooffer forward cover facility to FIIs to theextent of 15 per cent of the value of theirinvestments as on June 11, 1998. This facilitywas in addition to the facility alreadyavailable for incremental investments.

• Forward contracts have also been allowed forremittance of dividend in respect of directforeign investment.

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Elements ofReforms


7. Rupee basedderivatives

• No rupee based derivatives wereavailable.

• In April 1997, RBI permitted ADs to offerdollar-rupee swaps to corporates corporatesand run a swap-book within their openposition/gap limits without prior approval ofthe Reserve Bank of India.

• Once this was permitted themarket has seen forwarddeals upto 5 years whereasearlier a price beyond 6month was not available.

Rupee based derivativeswould be developed furtherwith the deepening of theforex market and theemergence of a stable rupeeyield curve.

8. ExchangeEarners'ForeignCurrency(EEFC)Account

• Exporters and exchange earnerswere not allowed to retain anyportion of their proceeds.

• Exporters and exchange earners are allowed toretain 50 per cent of their foreign exchangeearnings in the Exchange Earners’ ForeignCurrency (EEFC) accounts.

• 100 per cent EOUs are allowed to retain 70per cent of their earnings in such accounts.

• Since August 20, 1998, it was decided topermit exporters to use the balances in EEFCaccounts for all business related payments inIndia and abroad at their discretion includingpayments of airfare and hotel expenditure.

- The ultimate objective is toallow exporters andexchange earners to retain100 per cent of theirproceeds.

financial sector reform: review and prospects*

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